Understanding Finance: Areas, Investments, and Management

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

3. 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

4. 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

5. Simplified Financial System

6. 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

7. 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

8. 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

9. 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

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

11. 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

12. Accounting and FinanceBroad 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

13. 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

14. Figure 1-2 Finance Department Organization

15. Concept Connection Example 1-1 Accounting Records and Cash Flow 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

16. 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

17. 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

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

19. 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

20. 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

21. 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

22. Concept Connection Example 1-2 Tax Consequences of Business Form 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

23. 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

24. 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

25. 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

26. 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

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

28. 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?

29. 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

30. 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

31. 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