An Overview of Finance Areas within Finance Investments and financial markets Financial management of corporations Fields are separate but related 2

Financial Assets Real asset—Objects that provide services: houses, cars, food, etc. Financial asset—a document representing a claim to future income –Stock represents ownership interest –Bond represents a debt relationship Investing involves buying financial assets in the hope of earning more money (a return) –Investments can be made directly or indirectly through a mutual fund A Security is a financial asset that can be traded among investors 3

Financial Markets Securities are issued by corporations to raise money, and purchased by investors in financial markets –A framework or organization in which people can buy/sell securities Stock market Stockbroker is licensed to trade securities 4

Simplified Financial System 5

Raising Money The most common use of the word finance involves raising money to acquire assets Forms of Financing –Issuing stock - equity financing –Borrowing money - debt financing –Internal financing - retaining earnings 6

Raising Money The field of finance deals with both raising and investing money, but: Changing Focus of Finance –Past - finance was limited to financial market activity –Now – Corporate finance includes the financial management of organizations 7

Financial Management The management and control of money and money-related operations within a business CFO – chief financial officer (VP of finance) –Executive in charge of finance department 8

Financial Management Functions of the finance department: –Keeping records –Receiving payments from customers –Making payments to suppliers –Borrowing money –Purchasing assets –Selling stock –Paying dividends 9

Business Decisions Finance department provides: –Analyses to determine which assets are purchased and how they are financed –Oversight of how other departments spend money 10

The Price of Securities—A Link Between the Firm and the Market Two sides of finance – investments and financial management Investors buy securities for the cash income expected in the future Link between company management and investors comes from this relationship between price and expected financial results 11

Accounting and Finance Broad Portrayal vs. Cash Flow Accounting statements portray physical activity in numbers –Descriptive –Historical E.g. Depreciation The focus in Finance is on future cash flow In finance: Cash is King 12

Finance and Accounting Finance department generally consists of both the accounting and treasury departments –Controller is in charge of the accounting department –Treasury department deals with other other financial activities 13

Figure 1-2 Finance Department Organization 14

Concept Connection Example 1-1 Accounting Records and Cash Flow 15 A $1,000 asset depreciated straight-line over five years: Accounting perspective – Portrait Over Time Initial $1,000 cost becomes an asset on books $200 per year depreciation reduces profit Book value shrinks as depreciation accumulates Finance perspective – Focus On Cash Flow Depreciation deduction saves cash by reducing tax It took a $1,000 cash outflow to acquire the asset Where did the money come from Finance had to raise that money

The Language of Finance Accounting is the language of finance –All finance professionals need some knowledge of accounting Level depends on job –Financial analyst needs to know LOTS of accounting –Stockbrokers not as much 16

Financial Theory—The Relationship with Economics Modern financial theory began as a branch of economics in the 1950s –Originally called “financial economics” –Theoretical tools are very similar Finance is a separate but still related field 17

Figure 1-3 The Influence of Accounting, Economics and Financial Theory on Financial Management 18

Forms of Business Organization and Their Financial Impact A businesses can be legally organized as a –sole proprietorship –partnership –corporation Legal organization has an impact on –Raising money –Taxation –Financial liability For our purposes we’ll combine partner/proprietor 19

The Proprietorship Form Easy to start Taxes –Profit is taxed as personal income Taxed only once Raising money – Investor’s perspective –A proprietorship can only borrow (no stock to sell) But lending money to a new business is risky –Best outcome: repayment of principal and interest –Worst outcome: lose everything –Most new businesses fail Result: Collateral required 20

The Corporate Form Getting started –Requires a legal incorporation process Takes a little time, work and money Taxes –Double taxation Corporation pays corporate taxes on income Dividends paid to owners are taxed as personal income 21

Concept Connection Example 1-2 Tax Consequences of Business Form 22 A business earns $100,000 before taxes. Owner wants to take the earnings home. Tax rates: Corporate - 34% Personal - 30% Compare total tax bills under corporate and proprietorship forms of organization

The Corporate Form Raising Money –Borrowing –Same issues faced by sole proprietorship –BUT owner can now offer stock (equity) to investors –If sell less than 50% can maintain control –From the investor’s perspective –Stock is a risky investment but the reward may be worth it »Worst possible outcome: lose entire investment »Best possible outcome: get rich 23

The Truth About Limited Liability Limited liability: stockholder not liable for a corporation’s debts –Implies that the most a stockholder can lose is 100% of his investment in the stock –True for owners not involved in the business However, for owner operated small businesses –Personal guarantees make entrepreneurs liable for loans to their businesses –Legal system holds individuals liable for negligence –These destroy the value of limited liability 24

S-Type Corporations and LLCs Major advantage: Treated as a partnership with respect to federal income taxes –LLC is replacing S-type Government encourages small businesses because they create jobs –S-type corporations and LLCs Avoid double taxation: profits “pass through” to owners as personal income Offer limited liability Offer the ability to sell stock to raise money 25

Goals of Management Economics—goal is to maximize profit –Runs into short/long run problems –Example: What about R&D? Finance—goal is to maximize stockholders’ wealth by maximizing stock price –Investors take a broad look at corporate actions when bidding stock prices up or down 26

Stakeholders and Conflicts of Interest 27 Stakeholders that have an interest in the way the firm is operated include: Stockholders Employees Customers Community Management Creditors Suppliers

Conflicts of Interest An Illustration Employees want management to build a gym –Benefit — healthy employees are more productive –Cost — reduces stockholders’ return Conflict of interest between stockholders and employees –What if request for healthier working conditions? 28

Management—A Privileged Stakeholder Group Ownership of a widely held companies is very dispersed so no one has enough control to remove management Top management becomes entrenched controlling corporate resources They can use those resources for their own benefit 29

The Agency Problem Conflict of interest between stockholders and management –Agent is hired by a principal and given decision-making authority The Abuse of Agency –Privileges and luxuries provided to executives - ‘perks’ Controlling the Agency Problem –Manage the agency problem by: Monitoring management (audits) Tying executive compensation to stock performance 30

Creditors Versus Stockholders—A Financially Important Conflict of Interest Creditor - anyone owed money by a business –Especially bondholders If undertake high risk - high reward projects: –Losses shared by both stockholders and bondholders –But risk taking rewards all go to stockholders Bondholders receive only principal and interest Loan agreements can be written to prevent this kind of abuse 31