Practical Financial Management 3 rd Edition by William

Foundations Chapter 1 © 2003 South-Western/Thomson Learning

Main Areas of Finance Investments and financial markets n Financial management of corporations n n Fields are separate but related 3

Financial Assets n n Real asset—an object that provides a service, such as a house, car, art, coin… Financial asset—a document representing a claim to income n Stock—ownership interest in a company • Entitled to a share of the firm’s profits, either dividends or future growth n Bond—debt interest in a company • Entitled to interest and repayment of principal n Investing involves buying financial assets in the hope of earning a return n Can be made directly or indirectly (buying shares in a mutual fund) 4

Financial Markets n Financial Market n Financial assets are issued by corporations and bought by investors in financial markets • A framework or organization in which people can buy/sell securities • Stock market (NYSE, AMEX, OTC)--entire network of brokers and exchanges all connected together • Stockbroker (broker)--person who is licensed to trade securities for a commission 5

Financial Markets n Secondary market—place where investors trade securities among themselves (NYSE, etc. ) n n n Primary market—market where securities are initially sold (I. P. O. ) Investments n n Most transactions are of this type Making decisions about buying and selling stock and bonds Financial management n Decisions about raising money and how to spend it 6

Figure 1. 1: Simplified Financial System 7

Raising Money n n Financing means raising money to acquire something Forms of Financing n n Issuing stock (equity financing) Borrowing money (debt financing) • Bank • Issuing bonds • Leasing n Internal financing (retaining earnings) • Still considered equity financing 8

Raising Money Field of finance includes raising money and investing money n Changing Focus of Finance n Finance used to be narrowly limited to financial market activity n However has expanded to include n • Portfolio formation and analysis • A portfolio is a collection of securities • Financial management within an organization 9

Financial Management n n Financial Management is the management and control of money and money-related operations within a business Executive in charge of finance department n CFO: Chief Financial Officer (AKA: VP of Finance) • Typically reports directly to the President of the corporation 10

Financial Management n Refers to the functions of the finance department n n n n Keeping records Receiving payments from customers Making payments to suppliers Accounting Borrowing funds department is Purchasing assets included in the Selling stock broad definition of finance. Paying dividends, etc. 11

Financial Management n Business Decisions n Finance department is in charge of: • Determining which assets a firm should purchase • Acquiring another firm • Expanding operations • A different product line • Current operations expanding to another country • Deciding how those assets will be financed • Equity • Debt • Loan via bank • Bond issue 12

Financial Management n Oversight n Finance department must also perform an oversight function • Looking over everyone’s shoulder to make certain money is being used effectively • For example, • Are manufacturing costs too high? • Are advertising costs too high? 13

The Price of Securities—A Link Between the Firm and the Market n Investors buy securities for the future cash flows expected from them n n Price investors are willing to pay depends on expectations of how well the companies are likely to do Link between company management and investors comes from this relationship between price and expected financial results n Everything firm does is evaluated by market and ‘graded’ by either an , , or no change in security price 14

The Price of Securities—A Link Between the Firm and the Market n Does management care what ‘grade’ it receives? n YES! Why? • Management will need to issue new securities in the future (to raise $) and therefore want a high security price • Stockholders own the firm and if the stock price declines shareholders will be disgruntled 15

Finance and Accounting n Accounting: a system of record-keeping designed to portray a firm’s operations in a fair/unbiased manner n n Generate financial statements which are provided to the marketplace Finance: a process of decision-making related to raising money, analyzing results, etc. n Use the output generated by accountants as inputs in finance 16

Finance and Accounting n Finance department generally consists of both the accounting department and the treasury department n n n Controller is in charge of the accounting department Treasury department deals with finance activities Crossover is possible n Usually easier for an accountant to move to the treasury department 17

Figure 1. 2: Finance Department Organization 18

The Importance of Cash Flow Accounting attempts to reflect a firm’s financial results in a way that represents what is physically occurring n Finance is interested in how cash is flowing (or expected to flow) n n We need a cash amount because we’ll be looking at returns on money invested, and you can’t invest a non-cash number • Cash is King 19

The Importance of Cash Flow Example Q: Example: In 1999 we purchased a $1, 000 asset that will be depreciated over five years using straight-line depreciation. Explain how that asset will be viewed from both an accounting and finance viewpoint. A: Accounting: The initial cost of the asset of $1, 000 will be reflected on the books as will the $200 annual depreciation. Finance: We are interested in the $1, 000 cash outflow and the taxes saved from the depreciation deduction—not the depreciation itself. 20

The Language of Finance n Accounting is the language of finance n Thus all finance professionals need some accounting knowledge • Level of accounting knowledge needed depends on job • Financial analyst needs to know LOTS of accounting because s/he investigates companies and makes recommendations concerning their value in market (must decipher complex financial statements as part of that process) • Stockbrokers do not need as thorough an understanding because they generally trade securities based on the financial analyst’s recommendation 21

Financial Theory—The Relationship with Economics n Financial theory developed from economics n Modern financial theory began as a branch of economics in the 1950 s • Today finance is viewed as a separate field n Scholars in both fields make observations between business world and government and attempt to model the behavior 22

Figure 1. 3: The Influence of Accounting, Economics and Financial Theory on Financial Management 23

Forms of Business Organization and Their Financial Impact n Businesses can be legally or organized as n n Legal organization has an impact on n n A sole proprietorship A partnership A corporation Raising money Taxation Financial liability Issues really only important regarding small businesses n Virtually all large corporations are organized as C-type organizations 24

The Proprietorship Form n Getting started n n Easy to do Taxes n Profit is taxed as personal income to the business owner • Are taxed only once • Taxed at personal income tax rates n Raising money n If entrepreneur decides to go outside the firm to raise money, s/he can obtain a loan • Lending money is risky • Best possible outcome: repayment of principal and interest • Worst possible outcome: lose everything • Thus, most lenders require collateral • Many entrepreneurs use their house as collateral 25

The Corporate Form n Getting started n Requires a legal incorporation process • Takes time, work and money n Taxes n When business makes a profit taxes are paid twice • The corporation pays a tax at the corporate tax rate • Dividends paid to individuals are taxed at an individual’s personal tax rate 26

Example The Corporate Form—Example Q: Hazel Gilroy owns a business that earns $100, 000 before taxes. She wants to take the earnings home and spend them on herself. Assume a simplified tax system in which the relevant rates are 34% for corporations and 28% for individuals on the entire amounts subject to those taxes. Compare the total tax bills under the sole proprietorship and corporate forms of organization. A: Under the corporate form the $100, 000 is first subject to a 34% corporate tax of $34, 000, leaving earnings of $66, 000. If Hazel were to take these earnings she would have to declare them as a dividend and pay personal taxes at 28%, or $18, 480. In a sole proprietorship the $100, 000 is taxed only once at the personal rate of 28%, for a total tax bill of $28, 000. The difference in taxes of $24, 480 is significant. 27

The Corporate Form n Raising Money n Money for a corporation can be raised by • Borrowing • A corporation faces the same issues as a sole proprietorship when raising money • Offering stock to investors • If less than a 50% interest is sold, original owner still maintains effective control • Owning stock is risky • Best possible outcome: may get rich • Worst possible outcome: may lose all of your investment 28

The Truth About Limited Liability n Limited liability states that a stockholder is not liable for a corporation’s debts n n Implies that the most stockholder can lose is 100% of his investment in the stock In a sole proprietorship, the business owner stands to lose his personal property if all the assets of the business are insufficient to cover all liabilities n Personal guarantees make entrepreneurs liable for loans made to their business • Destroys the value of limited liability 29

S-Type Corporations n Major financial advantage of corporate form n n Major financial disadvantage n n Ability to raise money by issuing stock Double taxation of earnings Government encourages formation of small businesses because they create numerous jobs n Government allows creation of S-type corporation • Lets small businesses avoid double taxation • Offers limited liability • Offers ability to sell stock to raise money 30

Goals of Management n Economics—goal is to maximize profit n But what about R&D? • If you eliminate R&D you’ll increase short-term profit and hurt long-term profit n Finance—Stockholders own the company so the goal is to maximize their wealth, generally by maximizing the stock price n This goal bypasses the concern of whether the short -term or long-term is more important, because stock price incorporates both! • If R&D were eliminated the stock price would not rise, but rather, drop 31

Stakeholders and Conflicts of Interest n Constituencies of the company who have a vested interest in the way the firm is operated and include n n n n Stockholders Employees Customers Community Management Creditors Suppliers 32

Conflicts of Interest—An Illustration n Example: Employees want management to build an athletic facility on corporate grounds n n Benefit—more effective employees (feel better, happier, therefore more productive) Cost—will come from profits that belong to stockholders • This represents a conflict of interest between stockholders and employees • Something that benefits one group and takes away from another 33

Management—A Privileged Stakeholder Group n n Management represents a privileged stakeholder group The ownership of a widely held company is very dispersed so no one has enough control to influence management n n n IBM has almost 2 billion shares outstanding, and over 600, 000 shareholders—so no one person has enough control to influence management This allows top management to become entrenched in positions controlling large amounts of resources Management is able to use these resources for their own benefit 34

The Agency Problem n Management (agent) is controlling resources owned by stockholders (principal) and may not make the decisions stockholders want n The Abuse of Agency n Privileges and luxuries provided to executives are called perquisites or ‘perks’ • Example—management compensation • Management receives exorbitant salaries/bonuses ($50+ million) while the company performance is poor • Additional perks include boats, airplanes, country club memberships, etc. 35

The Agency Problems n Controlling the agency problem n Efforts to manage agency problem include • Monitor management (audits) • Tie management bonuses to corporate stock performance via a stock option or to corporate profit 36

Creditors Versus Stockholders—A Financially Important Conflict of Interest A creditor is anyone owed money by a business including lenders, vendors, employees, or the government n Actions taken by the leveraged company that are riskier than before they borrowed money place creditors at risk n Lenders generally put clauses in loan agreements to prevent this from occurring n 37