What is Finance? Finance is the study of how people and businesses evaluate investments and raise capital to fund them.
Corporate Finance addresses the following three questions: • What long-term investments should the firm choose? • How should the firm raise funds for the selected investments? • How should short-term assets be managed and financed?
Forms of Business Organization • The Sole Proprietorship • The Partnership • The Corporation
Sole Proprietorship It is a business owned by a single individual who is entitled to all of the firm’s profits and is responsible for all of the firm’s debt. The sole proprietors typically raise money by investing their own funds and by borrowing from a bank.
Sole Proprietorship (cont.) • Advantages: • Easy to start • No need to consult others while making decisions • Organization taxed at the personal tax rate • Disadvantages: • Owner is personally liable for the business’s debt • The business ceases on the death of the proprietor • Hard to raise money
Partnership: General A general partnership is an association of two or more persons who come together as co-owners for the purpose of operating a business for profit.
Partnership (cont.) • Advantages: • Relatively easy to start • Organization taxed at the personal tax rate • Access to funds from multiple sources or partners • Disadvantages: • Partners jointly share unlimited liability • It is not always easy to transfer ownership
Partnership: Limited • In limited partnerships, there are two classes of partners: general and limited. • The General Partner runs the business and faces unlimited liability for the firm’s debts • The Limited Partner does not run the business and is only liable up to the amount invested.
Corporation Are the big organizations. Generally established when very large sums of money are required. • Main defining characteristic is the separately of ownership (shareholders) from control (management) • The Board of directors are elected by the shareholder, and the board appoints the senior management of the firm.
Corporation (cont.) • Advantages • Liability of owners is limited to invested funds • Life of corporation is not tied to the owner • Easier to transfer ownership • Easier to raise Capital • Disadvantages • Greater regulation • Double taxation of dividends
Limited Liability Company (LLC) Limited liability company (LLC) combines the tax benefits of a partnership (no double taxation of earnings) with the limited liability benefit of corporation (the owner’s liability is limited to what they invest).
Five Basic Principles of Finance Time Value of Money Risk-Return Trade-off Cash is King Market Prices Reflect Expectations/News People do what is best for them, unless you make them change their mind
Time Value of Money • A dollar today is worth more than a dollar tomorrow • We can invest the dollar today and earn interest. Therefore, in the future we have the dollar invested plus interest
Risk-Return Trade-off • No one likes risk for its own sake. Therefore people will only take on more risk if they are compensated with higher returns • Higher the risk higher expected return • Note expected return may not be equal to the realized return.
Cash is King • Profit, Earnings, Net Income are accounting numbers designed to measure performance. • These numbers can be manipulated • Cash flows are the actual dollars flowing in and out of the company and can’t be manipulated as easy • It is possible for a firm to report profits but have no cash.
Cash is King: Follow on Financial decisions should only consider “incremental cash flow” i.e. the difference between the cash flows the company will produce with the new investment and what it would make without the investment.
Market Prices Reflect News Investors react quickly to news/information and decisions made by managers. Good News ==> Higher stock prices Bad News ==> Lower stock price.
The Goal of Financial Managers • What is the correct goal? • Maximize profit? • Minimize costs? • Maximize market share? • Maximize shareholder wealth?
The Financial Manager The Financial Managers increase shareholder wealth by: • Selecting value creating projects • Capital Budgeting Decision • Making smart financing decisions • Capital Structure Decision
Stocks and Bonds Money Primary Market Secondary Market securities money Financial Markets Investors Firms Bob Sue
Quick Quiz • What are the three basic questions Financial Managers must answer? • What are the three major forms of business organization? • What is the goal of financial management? • What is the difference between a primary market and a secondary market?
Financial Statements • Company managers, investors, and outside analysts use financial statements to conduct… • Cash flow analysis • Performance (ratio) analysis • The SEC requires U.S. companies to produce financial statements conforming to Generally Accepted Accounting Principles (GAAP), developed by the Financial Accounting Standards Board (FASB).
Basic Financial Statements The accounting and financial regulatory authorities mandate the following four types of financial statements: • Balance Sheet • Income Statement • Cash Flow Statement • Statement of Shareholder’s Equity
The Balance Sheet • A snapshot of the firm’s accounting value at a specific point in time • What does the company look like today • The Balance Sheet Identity is: • Assets ≡ Liabilities + Stockholder’s Equity • Left Hand Side of the balance sheet must equal the Right Hand Side
Total Value of Assets: Total Firm Value to Investors: Current Liabilities Current Assets Long-Term Debt Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Balance Sheet
2007 2006 Current assets: Cash and equivalents $140 $107 Accounts receivable 294 270 Inventories 269 280 Other 58 50 Total current assets $761 $707 Fixed assets: Property, plant, and equipment $1,423 $1,274 Less accumulated depreciation (550) (460) Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Total fixed assets $1,118 $1,035 Total assets $1,879 $1,742 U.S. Composite Corporation Balance Sheet The assets are listed in order by the length of time it would normally take a firm with ongoing operations to convert them into cash. Cash is the most liquid with intangible assets being the least liquid.
Balance Sheet Analysis • When analyzing a balance sheet, the Finance Manager should be aware of three concerns: • Liquidity • Debt versus Equity • Value versus Cost
Liquidity • Refers to the ease and quickness with which assets can be converted to cash—without a significant loss in value • Generally the more liquid the asset the lower the rate of return • Current assets are more liquid than fixed assets • The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term cash obligations (Ex. payroll) • A profitable but illiquid firm will experience financial distress
Debt versus Equity • Debt → Liability • Promise to payout cash, an IOU • Equity is the residual • Assets – Liabilities ≡ Equity • Debt represents a senior claim on firm assets • If the firm goes bankrupt debt holders get paid before equity holders
Value versus Cost • Accountants are historians, they care about what something cost when purchase • Under GAAP, financial statements carry assets at cost • Market value is the price at which assets, liabilities, and equity could actually be bought or sold, TODAY • Cost and Market Value are two completely different concepts • What did we pay for it, versus what can we sell it for
The Income Statement • Measures financial performance over a specific period of time • How has the company performed? • The accounting definition of income is: Revenue – Expenses ≡ Income • Generally the Income Statement is comprised of several parts:
U.S.C.C. Income Statement Total operating revenues $2,262 The operations section of the income statement reports the firm’s revenues and expenses from principal operations. Cost of goods sold 1,655 Selling, general, and administrative expenses 327 Depreciation 90 Operating income $190 29 Other income Earnings before interest and taxes $219 Interest expense 49 Pretax income $170 Taxes 84 Current: $71 Deferred: $13 Net income $86
U.S.C.C. Income Statement Total operating revenues $2,262 The non-operating section of the income statement includes all financing costs, such as interest expense. Cost of goods sold 1,655 Selling, general, and administrative expenses 327 Depreciation 90 Operating income $190 29 Other income Earnings before interest and taxes $219 Interest expense 49 Pretax income $170 Taxes 84 Current: $71 Deferred: $13 Net income $86
U.S.C.C. Income Statement Total operating revenues $2,262 Cost of goods sold 1,655 Selling, general, and administrative expenses 327 Depreciation 90 Operating income $190 29 Other income Earnings before interest and taxes $219 Usually a separate section reports the amount of taxes levied on income. Interest expense 49 Pretax income $170 Taxes 84 Current: $71 Deferred: $13 Net income $86
U.S.C.C. Income Statement Total operating revenues $2,262 Cost of goods sold 1,655 Selling, general, and administrative expenses 327 Depreciation 90 Operating income $190 Other income 29 Earnings before interest and taxes $219 Interest expense 49 Net income is the “bottom line.” Pretax income $170 Taxes 84 Current: $71 Deferred: $13 Net income $86
Income Statement Analysis • There are three things to keep in mind when analyzing an income statement: • Generally Accepted Accounting Principles (GAAP) • Non-Cash Items • Time and Costs
GAAP • The matching principal of GAAP dictates that revenues be matched with expenses. • Thus, income is reported when it is earned, even though no cash flow may have occurred.
Non-Cash Items • The income statements also makes allowances for expense where no money changes hands • Depreciation is the most apparent example. No firm ever writes a check for “depreciation.” • Another non-cash item is deferred taxes, which does not represent a cash flow. • Thus, net income is not cash.
Time and Costs • In the short-run, certain equipment, resources, and commitments of the firm are fixed, but the firm can vary such inputs as labor and raw materials. • In the long-run, all inputs of production (and hence costs) are variable. • Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs.
Taxes • “In this world nothing is certain but death and taxes.” Ben Franklin • Taxes represent a major cost to the firm • Taxes rules change, and are subject to political, not economic forces • What this means is that taxes do not need to make economic sense • Company is subject to two different tax rates • Marginal – the percentage paid on the next dollar earned • Average – the tax bill / taxable income
Marginal versus Average Rates • Suppose your firm earns $4 million in taxable income. • What is the firm’s tax liability? • .15(50,000) + .25(75,000 – 50,000) + .34(100,000 – 75,000) + .39(335,000 – 100,000) + .34(4,000,000 – 335,000) = $1,356,100 • Rate from table 2.3 • What is the average tax rate? • What is the marginal tax rate? • If you are considering a project that will increase the firm’s taxable income by $1 million, what tax rate should you use in your analysis?
Net Working Capital • Net Working Capital (NWC)≡ Current Assets – Current Liabilities • NWC is usually positive for a growing firm • Why?
$252m = $707- $455 2007 2006 2007 2006 Current assets: Current Liabilities: Cash and equivalents $140 $107 Accounts payable $213 $197 Accounts receivable 294 270 Notes payable 50 53 Inventories 269 280 Accrued expenses 223 205 Other 58 50 Total current liabilities $486 $455 Total current assets $761 $707 Here we see NWC grow to $275 million in 2006 from $252 million in 2005. Long-term liabilities: Fixed assets: Deferred taxes $117 $104 Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458 Less accumulated depreciation (550) (460 Total long-term liabilities $588 $562 Net property, plant, and equipment 873 814 Intangible assets and other 245 221 Stockholder's equity: Total fixed assets $1,118 $1,035 Preferred stock $39 $39 Common stock ($1 par value) 55 32 This increase of $23 million is an investment of the firm. $23 million Capital surplus 347 327 Accumulated retained earnings 390 347 $275m = $761m- $486m Less treasury stock (26) (20) Total equity $805 $725 Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742 U.S.C.C. Balance Sheet
Financial Cash Flow • As finance people what we are really interested in is the firm’s actual cash flow • Since there is no magic in finance, it must be the case that the cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders. CF(A)≡CF(B) + CF(S)
U.S.C.C. Financial Cash Flow Cash Flow from Assets Cash Flow to Investors Cash Flow of the Firm Operating cash flow $238 (Earnings before interest and taxes plus depreciation minus taxes) Capital spending -173 (Acquisitions of fixed assets minus sales of fixed assets) Additions to net working capital -23 Total $42 Cash Flow of Investors in the Firm Debt $36 (Interest plus retirement of debt minus long-term debt financing) Equity 6 (Dividends plus repurchase of equity minus new equity financing) Total $42
The Cash Flow Statement The Cash Flow Statement is used by firms to explain changes in their cash balances over a period of time by identifying all of the sources and uses of cash for the period spanned by the statement.
The Statement of Cash Flows • The three components are: • Cash flow from operating activities • Cash flow from investing activities • Cash flow from financing activities