Copyright© 2007 Cameron School of Business UNIVERSITY OF NORTH CAROLINA WILMINGTON An Introduction to Finance: Chapters 1 – 3 of Essentials of Corporate Finance Edward Graham Professor of Finance Department of Economics and Finance

Copyright© 2007 Outline of the Introduction to Finance Module Introduction to Finance I.The Three Primary Duties of the Financial Manager II.Evidence of the Results of Financial Decision-making: The Financial Statement and Ratio Analysis

Copyright© 2007 An Introduction to Finance What is finance? Finance is the study of the art and the science of money management; it is based on the Latin root finis, meaning the end. In managing ours or our firm’s money, we consider historical outcomes or “endings,” and we propose future results as a function of decisions made today. Those outcomes or results are typically portrayed using financial statements.

Copyright© 2007 I.The Three Primary Duties of the Financial Manager Whether managing monies for the home, or for the firm, our duties are met with decisions framed by the same general principles. These principles instruct us in making three main types of decisions as we perform those three primary duties: The capital budgeting decision The capital structure decision The working capital decision

Copyright© 2007 The Capital Budgeting Decision With the capital budgeting decision, the financial manager decides where best to deploy monies long-term. The purchase of a new delivery truck or a new warehouse is a capital budgeting decision; the payment of a utility bill is not. With the making of this decision, we consider three features of the cash flows deriving from the decision: The size of the cash flows The timing of the cash flows The risk of the cash flows We review a couple examples of capital budgeting decisions.

Copyright© 2007 The Capital Structure Decision With the capital structure decision, the financial manager decides from where best to acquire monies long-term. The purchase of that new delivery truck with cash or with a loan from GMAC or Ford Motor Credit is a capital structure decision; the use of long-term borrowing to fund a franchise purchase is another. Perhaps most importantly, the decision to fund a firm’s growth with equity - such as with funds invested by the firm’s founders, angel investors, venture capitalists or public stock offerings – or debt, is a critical capital structure choice. Two features of this choice bear mentioning: The risk of the debt The loss of control and reduced potential cash flows to the founders with an equity or stock sale We expand our review with a few capital structure decisions.

Copyright© 2007 The Working Capital Decision With the working capital decision, current assets and current liabilities become the focus of the financial manager. Such items as cash balances, accounts receivable, inventory levels and short-term accruals (such as prepaid rent or utilities) are included among the short-term assets that comprise one component of working capital. Also with the working capital decision, we concern ourselves with short-term obligations such as accounts payable to vendors, and other debt that is expected to be paid off within one year. Net working capital is a meaningful outcome of the working capital decision-making matrix. Net working capital is merely the difference between current assets and current liabilities.

Copyright© 2007 II.Evidence of the Results of Financial Decision- making: The Financial Statement and Ratio Analysis Providing valid and timely information to the varied stakeholders in the firm is key. These stakeholders, both within and outside the firm, include the owners, the employees, neighbors, the community-at large, suppliers, lenders, bankers, and the competition. This information is typically provided within financial statements, and notes to those statements. Three statements attract our attention: The Income Statement The Statement of Cash Flows The Balance Sheet

Copyright© 2007 Ratio Analysis Five types of ratios support our discussion, and underscore important features of the information we are providing our varied stakeholders: Short term solvency Long term solvency Asset management Profitability Market value We briefly discuss each of these in turn, with examples of each type of ratio drawn from your earlier work in accounting, and illustrated by the example in class.

Copyright© 2007 The Example in Class, Inc. Balance Sheet at Year’s End Assets Liabilities & Owner’s Equity Current AssetsCurrent Liabilities Cash50,000 Payables50,000 Receivables20,000 Inventory30,000 Total Current Assets100,000Total C/Liabilities50,000 Fixed Assets150,000Long Term Liab.100,000 Total Liabilities150,000 Total Assets250,000 Owner’s Equity Par Value10,000 APIC40,000 Ret. Earnings50,000 Total Owner’s Eq.100,000 Total Liab and O/E250,000

Copyright© 2007 The Example in Class, Inc. Short Term Solvency Ratios –Current Ratio: current assets/current liabilities = 100,000/50,000 = 2 –Quick Ratio: (current assets – inventories)/current liabilities »= (100,000 – 30,000)/50,000 = 1.4 Long Term Solvency (or Debt) Ratios –Debt Ratio: total liabilities/total assets = 150,000/250,000 =.6 –Debt-to-Equity Ratio: total debt/total equity = 150,000/100,000 = 1.5 –Equity Multiplier: total assets/total equity = 250,000/100,000 = 2.5 What is the meaning of the each of the metrics? For example, what does a current ratio of “2” really mean? The quick ratio? The Long Term Solvency measures?

Copyright© 2007 The Example in Class, Inc. Assume our firm had sales in the most recent year of $200,000 and Net Income of $20,000. EIC, Inc. has 10,000 shares outstanding. Those shares were initially issued for $5 each with a par value of $1 per share. With net income of $20,000, EPS or Earnings Per Share becomes 20,000/10,000 or $2. Book value per share is total equity divided by shares outstanding or 100,000/10,000 or $10 per share. Dividends were $1 per share or a total of $10,000. Thus, the firm paid out 50% of earnings (dividends paid/net income = the dividend payout ratio of 10,000/20,000 or 50%) Asset Utilization Ratios –Total Asset Turnover: sales/total assets = 200,000/250,000 =.8 –Average Age of Receivables: 365 days/(sales/accounts receivable) »= 365 days/(200,000/20,000) = 36.5 days And how best might we interpret these asset utilization ratios?

Copyright© 2007 The Example in Class, Inc. Profitability Ratios –Profit Margin: net income/sales = 20,000/200,000 =.1 –Return on Assets (ROA): net income/total assets »= 20,000/250,000 =.08 –Return on Equity (ROE): net income/owner’s equity »= 20,000/100,000 =.20 Now assume EIC has a stock price of $40 per share Earnings per share (EPS) was $2 or 20,000/10,000 (net income/shares outstanding) Book value per share was 100,000/10,000 or $10 (owner’s equity/shares outstanding) Market Value Ratios –Price-Earnings ratio: price per share/EPS = 40/2 = 20 –Market-to-Book ratio: price per share/book value per share = 40/10 = 4 How do we interpret these final financial ratio examples?

Copyright© 2007 The Example in Class, Inc. The DuPont Identity : ROE = PM x T/A T/O x EM or ROE = NI/Sales x Sales/Total Assets x Total Assets/Equity =(20,000/200,000) x (200,000/250,000) x (250,000/100,000) NI/Sales reflects the impact of operations Sales/Total Assets reflects the impact of the capital budgeting decision Total Assets/Equity reflects the impact of the capital structure decision For EIC: ROE = (.10) x (.8) x (2.5) =.20, as before.