Chapter 1

1. Chapter 1 Foundations

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

3. Financial Assets • Real asset—an object that provides a service, such as a house, car, art, coin… • 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. 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 • Bank • Issuing bonds • Leasing is like borrowing • Internal financing - retaining earnings

5. 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 - it includes: • Goals and activities of investors: Portfolios • The financial management of organizations

6. Financial Management • Functions of the finance department: • Keeping records • Receiving payments from customers • Making payments to suppliers • Borrowing funds • Purchasing assets • Selling stock • Paying dividends • Analysis of business decisions • Oversight of other departments

7. Business Decisions • Finance department provides analyses to: • Determine which assets are purchased • Acquiring another firm • Expanding operations • Decide how those assets are financed • Equity • Debt • Oversight • Finance department oversees how other departments spend money

8. The Price of Securities—A Link Between the Firm and the Market • Two sides of finance – investments and financial management – connected since firms sell securities to investors in financial markets • Investors buy securities for the future cash flows expected from them • Link between company management and investors comes from this relationship between price and expected financial results

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

10. Finance Department OrganizationFigure 1.2

11. Accounting creates statements that are designed to portray what is physically occurring in numbers Finance is concerned with current and future cash flow In finance: Cash is King The Importance of Cash Flow

12. 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. Example The Importance of Cash Flow

13. The Language of Finance • Accounting is the language of finance • Finance professionals need some accounting knowledge • Level of accounting knowledge depends on job • Financial analyst needs to know LOTS of accounting • Stockbrokers do not need as much

14. The Truth About Limited Liability • Limited liability states that a stockholder is 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 made to their business • Legal system holds individuals liable for negligence • These destroy the value of limited liability

15. S-Type Corporations and LLCs • Major advantage: Treated as a partnership with respect to federal income taxes • LLC is replacing S-type • Government encourages formation of small businesses because they create jobs • S-type corporations and LLCs • Let small businesses avoid double taxation • Offer limited liability • Offer the ability to sell stock to raise money

16. Goals of Management • Economics—goal is to maximize profit • Runs into short/long run problems • What about R&D? • Finance—goal is to maximize stockholders’ wealth by maximizing stock price • Bypasses the concern of whether the short-term or long-term is more important, because stock price set in the financial market incorporates both!

17. 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

18. Conflicts of InterestAn Illustration Example: Employees want management to build an athletic facility on corporate grounds • Benefit—more effective employees (feel better, happier, therefore more productive) • Cost—will come from profits that belong to stockholders • Represents a conflict of interest between stockholders and employees • What if the request was for healthier working conditions?

19. Creditors Versus Stockholders—A Financially Important Conflict of Interest • Creditor - anyone owed money by a business including lenders, vendors, employees, or the government • If actions of the borrowing firm become riskier than before loan, creditors/lenders are subject to more risk • But risk taking rewards all go to stockholders • Lenders put clauses in loan agreements to prevent this