An Overview of Finance

Areas within FinanceInvestments and financial marketsFinancial management of corporationsFields are separate but related

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Financial AssetsReal 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

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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 marketStockbroker is licensed to trade securities

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Simplified Financial System

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Raising Money

The most common use of the word finance involves raising money to acquire assetsForms of Financing– Issuing stock - equity financing– Borrowing money - debt financing– Internal financing - retaining earnings

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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

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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

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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

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Business Decisions

Finance department provides:– Analyses to determine which assets are

purchased and how they are financed– Oversight of how other departments

spend money

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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

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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 flowIn finance: Cash is King

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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

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Figure 1-2 Finance Department Organization

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Concept Connection Example 1-1 Accounting Records and Cash Flow

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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 profitBook value shrinks as depreciation accumulates

Finance perspective – Focus On Cash Flow Depreciation deduction saves cash by reducing taxIt took a $1,000 cash outflow to acquire the asset Where did the money come from Finance had to raise that money

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

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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

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

Management

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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

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The Proprietorship Form

Easy to startTaxes– Profit is taxed as personal income

Taxed only onceRaising 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

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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 incomeDividends paid to owners are taxed as personal income

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Concept Connection Example 1-2 Tax Consequences of Business Form

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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

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

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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

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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 incomeOffer limited liabilityOffer the ability to sell stock to raise money

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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

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Stakeholders and Conflicts of Interest

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Stakeholders that have an interest in the way the firm is operated include:

StockholdersEmployeesCustomersCommunityManagementCreditorsSuppliers

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?

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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

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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

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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

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