Session 1

1. Session 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

3. Basic Areas Of Finance • Corporate finance = Business Finance • Investments • Financial institutions • International finance

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

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

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

7. Financeand … • 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

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?

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?

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

11. 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 Sole Proprietorship Business owned by one person

12. 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 Partnership Business owned by two or more persons

13. 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) Corporation A legal “person” distinct from owners and a resident of a state

14. International Corporate Forms • Joint stock companies • Public limited companies • Limited liability companies • All share: • Public ownership • Limited liability

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

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?

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

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

19. Cash Flows Between the Firm and the Financial MarketsFigure 1.2

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

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

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

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

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?

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

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

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

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?

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.

30. !! Cash Flow !!

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

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

33. Prufrock CorporationBalance Sheets - Table 3.1

34. Prufrock CorporationCommon-Size Balance SheetsTable 3.2

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

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

37. Table 3.5

38. Liquidity Ratios • Current Ratio = CA / CL • 708 / 540 = 1.31 times • Quick Ratio = (CA – Inventory) / CL • “Acid Test” • (708-422) / 540 = 0.53 times • Cash Ratio = Cash / CL • 98/ 540 = .18 times

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

40. Financial Leverage Ratios • Times Interest Earned = EBIT / Interest • 691/141 = 4.9 times • Cash Coverage = (EBIT + Deprec) / Interest • (691 + 276) / 141 = 6.9 times

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

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

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

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%

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

46. Prufrock Ratios

47. Table 3.6

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

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

50. Prufrock’s DuPont Identity • ROE = PM * TAT * EM • PM = 15.7% • TAT = .64 • EM = 1.39 • ROE = .157 x .64 x 1.39 = .139667 = 14%