Class 1 – Chapters 1

Class 1 – Chapters 1 Introduction to the study of Finance

What is Finance? Finance is a relatively new science – most big discoveries in finance have been made within the last few decade. (Versus, say, math in which Aristotle and others made large contributions.)

Finance – Sub-disciplines • Consider these traditional sub-disciplines of finance: • Corporate Finance– includes working capital management, capital budgeting, obtaining financing, capital structure decision, and dividend payout policies. (I.e. How do corporations act?) • Investments– includes company and security analysis, portfolio theory and management, futures and options. (Will be helpful for your Trading Game Project) • Markets and Institutions– includes banking, analysis of interest rates, and financial market microstructure. • Specialty Areas– includes real estate, insurance, law and financial economics, personal financial planning, enterprise finance, risk management, etc.

Finance – The corporate Pyramid • Like all organizations most corporations have an established hierarchy of power and responsibility. • Consider the above: IBM’s financial group Hierarchy • The finance group generally reports to the “CFO” who reports to the “CEO” who reports to the Board of Directors. They hire/fire the CEO. They are typically not employees of the company. The BOD reports to the Shareholders. (Think Mr. Deeds.)

Finance – The Corporate Pyramid • Usually each share of common stock represents one vote. So when you buy stock not only are you hopefully receiving profits but you are buying a stake in company management.

Company Cash Flow Cycle • Definition – wealth is any capital or asset that provides returns over time. • Markets transfer ownership of wealth (Wal-Mart owns the groceries you buy the groceries, now you own them.) • Two Market types • Financial – exclusively trade paper claims and obligations, contracts promising to deliver returns through time. I.e. Stocks, bonds, etc. • Real Asset – trade goods and services. I.e steel, groceries, real estate, etc. Figure 1.3 Illustrates the relation between financial and real asset markets. The company is at the heart of the cash flow cycle. It needs capital to produce a good or service, which it receives from financial markets. It needs materials, workers, clients, and perhaps government assistance – provided by Real Asset Markets.

Stakeholders • Definition – A stakeholder is an economic entity in the real asset market that exchanges goods and services with the company. • 4 types: • Suppliers – supply raw materials • Labor – management and employees. Supplies labor services. • Government – provide highways and airports, protect property, etc. • Clients – Notice difference in direction of arrow. Client supplies revenues with the company for goods and services

Financial Markets • Companies needing to raise money can do so by selling securities to capitalists in the financial markets. • Financial securities do no provide real goods and services, rather they represent an ownership claim on assets or goods and services. • Many types of financial markets and many schemes for categorizing them. • E.g. Primary vs. Secondary. • Primary – companies receive money by selling or issuing securities to capitalists. • Secondary – capitalists re-sell securities to other capitalists. (Think trading stock) • Stock in a company exists because a firm decides to go public, sell stock, and issue an IPO. All prior transaction are secondary market transactions. • http://www.msnbc.msn.com/id/43609396/ns/business-us_business/t/farmville-creator-zynga-go-public/

Financial Markets • Other market schemes include: • Money Markets vs. Capital Markets – depends on the length of the financial contract’s time horizon. Within one year – Money Market. • Credit vs Equity markets – depends on type of repayment promise. Credit markets include all short-term financing arrangements available in the money market. Also include long-term debt arrangements such as bonds and mortgages. Equity markets are essentially stock markets. • Credit Markets specify exact payments to be made at a future date. • Equity Markets make no legally bind promise. Dividends may or may not be issued.

Agency Problems • An agency problem potentially exists when a source of financing delegates decision-making authority for using the funds. • I.e. the owner of wealth does not control how the wealth is used. • The owner of the wealth is called the principal. The decision-maker is called the agent. • This misalignment of interest may lead to sub-optimal company performance. This lower performance, a result of an agency problem is called an agency Cost. • Three important Principal Agent relationships within a company: • Shareholders versus Management • Who is in charge of Management? What do shareholders want? • Creditor versus management/shareholder • Do the interests of bond holders and stock holders align? • Employee versus management/shareholder • Does management always act in the best interest of employees?

Wealth Creation and the Company Goal • What is the end result, hopefully for a company? • Wealth! • A company takes equity and credit from capitalists, purchases the necessary items from stakeholders and uses its facilities to create a product or offer a service which it then sells to clients in return for some amount of revenue. All revenue is passed on to capitalists and stakeholders. • If revenue equals production costs -> Economic Profit is ZERO!

Wealth Creation and the Company Goal • Residual wealth flows to equity – excess profits tend to shareholders. • Note – As this excess wealth appears stakeholders and/or creditors notice and lobby for a piece of the action. Competition and market structure determines who receives this economic profit. • In the “long-run” Economic profit is ZERO. What is the long –run? Does economic profit exist today? Why? • What is the company objective?

Managerial Compensation • Why are manager’s paid so much? • Stakeholders must be managed – fair wages and fair prices • Economic profit must be distributed fairly – are shareholders and creditors happy? • Is company wealth being maximized? • The change through time of equity stock price is a useful indicator of managerial effectiveness. • Perhaps this is why managerial compensation hinges upon stock price so often.

Different Company Types • Corporate Businesses • Corporations have issued stock. Stock traded on the stock exchange have “ticker symbols” I.e. WMT = Wal-Mart Stores, Inc. • There are vast differences among corporations:

Corporation Advantages • Why Incorporate? • Limited Owner Liability • Easy transferability and sharing of ownership • Potentially infinite life (business can outlive owner) • Easier access to financial markets • Disadvantages? • Legal obligations for corporations are sometimes quite complex • Corporate income is subject to “double taxation” • Taxes are paid on profits made, then those who receive the profits (in the form of dividends) pay taxes as well. • E.G Warren Buffet’s Berkshire Hathaway does not pay dividends. Indeed Buffett opposes lower dividend taxes. • Buffett states that BH’s 2006 tax return totaled 9,386 pages.

Noncorporate Business • Sole Proprietorship • Most prevalent type of business organization • Anyone can be a sole proprietor • File individual income tax returns (form 1040) and attach a Schedule C summarizing business income and expenses. • Advantages: • Relatively easy start-up and record-keeping requirements • There is no double-taxation (No dividends) • Disadvantages: Usually a lack of corporate advantages • Unlimited liability and personal wealth is at risk • Ownership not easily transferred, company lifetime is somewhat limited (Think Crimson Café) • Access to financial markets is linked to the collateral provided by the proprietor

Households • Households are as complex as running small companies. • Goods are purchased, resources are utilized to offer services, etc. • Households are the largest economic entity in the U.S.A. • Indeed the root word of economics, οἰκονομία, means “Management of a household.”

Chapter 2 Financial Fundamentals of Accounting

Accounting • Accounting is the “language of business”– It ensures exactness • However, accounting knowledge alone will not ensure profitability. A strong understanding of financial principals helps assure financial success. Together, finance and accounting for the foundation of business science. • Accounting Fundamentals are discussed in chapter 2.

Flows and Balances • Definition – Cash Flows represent transfers of wealth over time. • Definition – Balances represent accumulations of wealth – a snapshot of wealth at a particular time. • Cash Flows • e.g. your monthly rent payment - $550 per month is a flow, $6000 per year is a flow. • A transfer of wealth per unit time. • A cash flow always embodies a time period, regardless of time length. • Hourly wage • Yearly Profit • Career Earnings • There are cash inflows – sales and loans, etc • And Cash outflows – rent, fixed costs, etc. • Cash Flows signal changes in wealth

Flows and Balances • A balance is not a transfer of wealth per unit time. • A balance is an accumulation of wealth at a point in time i.e. a snapshot of wealth. • E.g. Credit Card balance, checking account balance, etc. • What the company owns – Asset Balances • What the company owes – Liability Balances • The sum of all asset balance equals the sum of all liability balances • Cash flows accumulate to form balances. • e.g. savings – saving $20 a week (a cash flow) accumulates after a month to a balance of $80.

Accrued versus Realized • Flows can be accrued or realized • A realized cash flow is a transfer of wealth accompanied by a flow of funds • E.g. Making a loan payment – the businesses wealth is lowered and the cash is sent to the bank. • A transfer of wealth per unit of time that is not accompanied by a flow of funds is an accrued cash flows. • E.g. Interest on a loan. Suppose the interest is charged daily. The interest represents a transfer of wealth that is not immediately followed by a flow of funds (perhaps you make a monthly payment.) • Land Rich, Cash Poor • Farmers may have much land that has increased in value, but the value is only accrued until it is sold – then it is realized. • Stock Market • You only have a loss when you sell your stock.

Company Financial Statements • 2 general purposes: • Provide company with useful information for monitoring and evaluating performance and financial situation. • Provide outside analysts with information regarding the particular firm’s financial health. (See “Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage.”) • FASB (Financial Accounting Standards Board) issues rules followed by most preparers of financial Statements, GAAP (Generally Accepted Accounting Principles,) that results in two general types of financial statements: • Those showing Flows (income statement and statement of cash flows) • Those showing Balances (Balance sheet)

The Balance Sheet • Balance Sheet (BS) summarizes the many different types of wealth that the company owns (assets) and owes (liabilities.) • Some corporations prepare quarterly financial statements, almost all prepare yearly financial statements. • Consider 2010 Balance Sheet of Yum! Brands, Inc. (YUM) • Liabilities – financing sources • current liabilities – claims that are paid within one business cycle (generally a year.) Can you think of a non-year business cycle? • long-term liabilities – claims paid after one business cycle

Liabilities • Current Liabilities – Payment due within one business cycle • Represents available financing. • Also suggests the future payment necessary in the near future. • Payables – financing , or trade credit, made available by suppliers for purchasing inventory and other assets. (E.g. consider your credit card.) • Accruals – money a company owes its workers for completed jobs, but remains unpaid. • Short term notes – short-term bank loans (E.g. buying a blu-ray at Best-Buy with 6-months no interest.) • Long-Term Liabilities – Wealth company repays in remote future. • Long-Term Debt consider bank loans or long-term bonds • Other Long-Term liabilities – consider retirement benefits from (near) retirees, Pension agreements • Stockholders’ equity – measures all cash lent to the company by stockholders. Sometimes called Net Worth. Net Worth equals total assets minus total liabilities.

Stockholders' Equity • Stockholders’ equity, or net worth, belongs to Stockholders. • Dividing SE by the number of shares outstanding equals the Equity Book Value per share. • If financial statements properly reflect true values, and if the stock market accurately prices shares, then market shareprices should equal the equity book value per share.

Stockholders’ Equity • The ratio of stock market shareprice to equity book value is the “equity price-to-book” ratio: P/B ratio. • A P/B ratio equal to 1 implies a dollar of company assets has a price in the share market of exactly one dollar. • A small P/B ratio (lower than one) may imply the market undervalues the assets (perhaps then one should buy it in hope that the market corrects itself) or that the company’s book value is inaccurate. • A Large P/B ratio (higher than one) may imply that the market overvalues the assets.

Market Capitalization • Plug formula 2.1 into Formula 2.2 and get a similar equation (written on board.) • Notice the product of the numerator equal the product of market shareprice and total number of shares outstanding. This represents the company’s Market Capitalization.

Mergers and Acquisitions • Suppose one company takes control of another company: • one company, the Raider, gets control of an amount of common stock in another company, called the Target • Read Street-Bite p. 30 in book.

Merger Example The raider has 550 common shares outstanding with a P/B ratio = 0.54. The Target company has 220 common shares outstanding and their P/B ratio = 1.23 The raider offers 9 shares of Raider Stock to Target Shareholders that tender 2 Target shares. Find 1.) The P/B ratio for the new Conglomerate Company, and 2.) The effect of the merger on each shareholders’ wealth?

Homework • Do FF20, FF29, FF32, FA3, FA3F, FF5, FF25, FF31 • **Note no need to do word problems twice. All problems with calculations must be done twice.

Class 1 – Chapters 1