Chapter 1 Mgt 326 Fall 2012

Why Study Finance?

How Firms are Organized Sole proprietorship – Easy – Most common Partnerships – Business run by more than one owner – Limited partnership – limited liability

How Firms are Organized Limited Liability Companies – All owners have limited liability – Flow through tax benefits – Set up to protect professionals in a partnership due to poor performance or misconduct by one partner. Ex: malpractice suit.

How Firms are Organized Corporations – Legally defined, artificial being, separate from its owners Formation – Must be legally formed. – Difficult Ownership – Shareholders are the owners. Dividend payments are made to the shareholders at the discretion of the corporation. Payment is proportional to the amount of shares held. Taxation – S Corp – C Corp

How Firms are Organized Corporations Taxation – S Corp Taxed once All profits pass through stock holders, no tax is paid at the corporate level – C Corp Subject to taxation separate from the owners tax obligations In effect shareholders pay tax twice on the corporations profits This is referred to as double taxation

How Firms are organized - summarized Proprietor or Partnership Advantages- Easy to set up Owner manager make decisions Less regulated Single taxation Disadvantages Unlimited Liability Life of the business is limited to the life of the owner. Difficult to transfer ownership Hard to raise capital Corporation Advantages Liability limited to the amount invested Easy to transfer ownership Unlimited life Disadvantages Harder to set up Double Taxation Highly regulated by the Fed. Owner Manager conflicts

Tax Implications for Corporations Example You are a shareholder in a corporation. The corporation earns $5.00 per share before taxes. After it has paid taxes, it will distribute the rest of its earnings to you as a dividend. The dividend is income to you so you will then pay taxes on these earnings. The corporate tax rate is 40%, and your tax rate on the dividend is 15%. How much of the earnings remain after all taxes are paid?

What do Financial Manager’s do? Make Investment Decisions – Weigh the cost and benefit of each investment / project – Decide whether they are good uses of the available money Make Financing Decision – Will the manager finance the decision using additional stock or issue debt Manage Cash Flow. – Make sure the company has enough cash to meet the day to day obligations. Goal of the financial Manager – Maximize the wealth of the stockholders.

What do Financial Manager’s do? Goal of the financial Manager – Maximize the wealth of the stockholders. Unambiguous objective Easy to Measure Public traded are perfect for this due to the large number of buyers / sellers Forces securities to trade near their true price

The Corporate Management Team 1 Cash & Credit Mgmt 2 Inventory Management 3 Capital Budgeting 4 Planning and Forecasting Board of Directors President / CEO VP: MarketingVP Finance (CFO)VP: Manufacturing ControllerTreasurer 1Cost Accounting 2Financial Accounting 3Tax Management

Agency Conflicts Agency Problems – When managers, despite being hired as the agents of shareholders, put their own self-interest ahead of the interests of the shareholders

Agency Conflicts What can be done to eliminate Agency Problems – Tie Performance to compensation – Shareholders can force a resignation – Hostile take over – Legal & Regulatory Environment Sarbanes-Oxley – also known as the Truth in Securities Act

Ethics in Business Agency Costs – Act Honestly – Deception & Fraud can have a huge & long lasting effect on stock price Could cause bankruptcy as with Enron and WorldCom Conflicts of Interest – Dual Function Disclosure Sometimes law requires one party to withdraw

Ethics in Business (cont) Information Asymmetry – One party has information the other does not Inside information illegal Truth in Negotiations

Ethical Consequences Bernard Ebbers – WorldCom – Guilty of Fraud – Sentenced to 25 yes jail time Bernard Madoff – Pleaded guilty to 11 federal felonies – massive ponzi scheme – Sentenced to 150 years in prison – Maximum allowed

The Stock Market The stock market provides liquidity for a company’s shares and determine the market price. Primary Market – Issues new shares. These go to investors Secondary Market – Shares trade between investors, with out the involvement of the corporation. The stock market acts as a score card for management and how well of a job they are doing, based upon the stock price.

NYSE Physical Location Market Makers or Specialist – Individuals on the trading floor of a stock exchange who match buyers with sellers – They post two prices for every stock they make a market for Bid price – Ask price – – The Specialist will buy or sell (up to a limited amount of shares) and make the trade, even if they don’t have another customer willing to take the other side of the trade. – This way they make sure the market is liquid

NYSE cont Auction Market – Licensed holders can go to the companies trading posts and directly sell or buy shares Bid Ask Spread – Transaction cost – Small spread

NASDAC National Association of Security Dealers Automated Quotation – Over the Counter (OTC) Market – The major difference between NYSE and NASDAC is that on the NYSE each stock only has one market maker – On NASDAC, stocks can and do have multiple market makers who compete with each other Each Market maker must post bid and ask prices in the NASDAQ network where they can be viewed by all participants. The NASDAQ system posts the best prices first and fills orders accordingly

Listing Standards These are the requirements that have to be met to be traded on the exchange. – Require enough shares for liquidity. – The two exchanges compete over the listings of larger companies.

Financial Institutions Banks and Credit Unions – Deposits Loans money to people Insurance companies – Premiums and investment earnings Invests mostly in bond, some stocks, using the investment income to pay claims Mutual Funds – Peoples investments (savings) Buys stocks bonds and other financial instruments on behalf of its investors

Financial Institutions Pension Funds – Retirement savings contributed through the workplace Similar to mutual funds, except with the purpose of providing retirement income. Hedge Funds – Investments by wealthy individuals and endowments Invests in any kind of investment in an attempt to maximize returns.

Financial Institutions Venture Capital – Investments by wealthy individuals and endowments Invest in start up, entrepreneurial firms Private Equity Funds – Investments by wealthy individuals and endowments Purchases whole companies by using a small amount of equity and borrowing the rest.

Factors that influence stock prices Internal Factors (ie influenced by management) – Projected Earnings Per Share – Timing of projected earnings – Riskiness of the projected earnings – Debt Policy – Dividend Policy

Factors that influence stock prices External factors (ie beyond management’s control) – Antitrust laws – Environmental regulations – Product and workplace safety regulations – Federal Reserve Monetary Policy – Government Fiscal Policy – International Developments

What Jobs Can Finance majors pursue? Private sector – Stock Broker – Personal Investment Counselor Public Sector – Program Manager – Budget Analyst – Cost Analyst Corporations and Small Businesses – Budget Analyst – Cost Analyst – Capital Manager – Program Manager

The Difference between Finance & Accounting Finance – Focused on the future – Deals with uncertainty – Primarily concerned with deciding how to acquire, generate and distribute assets & capital resources – Strategic decision making

The Difference between Finance & Accounting Accounting – Focused on the past – Very little uncertainty – Primarily concerned with keeping track of how assets and capital are distributed – Limited decision making

Risk The chance that an outcome other than that which was expected will occur For finance Risk = Uncertainty of cash flows

Rate of Return Also known as Yield, Return on Investment (ROI), Profit Percentage The percent increase in the price of a financial asset Formula for calculating RoR – (Sales – COGS) / COGS – (New Price – Old Price) / Old Price

Rate of Return (cont) In finance we are more concerned with RoR than we are Profit – Consider the 2 investments

Rate of Return (cont) The second option has a higher profit, however the first option was more profitable because you got more money with respect to the amount of money invested. Investments expressed as RoR can be compared on the same basis with out bias.

What are the goals of the Corporation? The primary goal is to Maximize Shareholder Wealth – Why – How is this measured