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Four Basic areas
- 1. Corporate finance
- 2. Investments
- 3. Financial Institutions
- 4. International Finance
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Corporate Finance
Business finance more applicable.
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Investments
- Work with financial assets such as stocks and bonds
- Value of financial assets, risk versus return, and asset allocation
- Job opportunities
- Stockbroker or financial advisor
- Portfolio manager
- Security analyst
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FINANCIAL INSTITUTIONS
- Companies that specialize in financial matters
- Banks – commercial and investment, credit unions, savings and loans
- Insurance companies
- Brokerage firms
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INTERNATIONAL FINANCE
- An area of specialization within each of the areas discussed so far
- May allow you to work in other countries or at least travel on a regular basis
- Need to be familiar with exchange rates and political risk
- Need to understand the customs of other countries; speaking a foreign language fluently is also helpful
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BUSINESS FINANCE
Some important questions that are answered using finance
- What long-term investments should the firm take on?
- Where will we get the long-term financing to pay for the investments?
- How will we manage the everyday financial activities of the firm?
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FINANCIAL MANAGER
- Financial managers try to answer some, or all, of these questions
- The top financial manager within a firm is usually the Chief Financial Officer (CFO)
- Treasurer – oversees cash management, credit management, capital expenditures, and financial planning
- Controller – oversees taxes, cost accounting, financial accounting, and data processing
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Capital budgeting
What long-term investments or projects should the business take on?
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Capital structure
- How should we pay for our assets?
- Should we use debt or equity?
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Working capital management
How do we manage the day-to-day finances of the firm?
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SOLE PROPRIETORSHIP
- Business owned by one person
- Advantages
- Easiest to start
- Least regulated
- Single owner keeps all of the profits
- Taxed once as personal income
- Disadvantages
- Limited to life of owner
- Equity capital limited to owner’s personal wealth
- Unlimited liability
- Difficult to sell ownership interest
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PARTNERSHIP
- Business owned by two or more persons
- Advantages
- Two or more owners
- More capital available
- Relatively easy to start
- Income taxed once as personal income
- Disadvantages
- Unlimited liability
- General partnership
- Limited partnership
- Partnership dissolves when one partner dies or wishes to sell
- Difficult to transfer ownership
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CORPORATION
A legal "person" distinct from owners and a resident of a state
- Advantages
- Limited liability
- Unlimited life
- Separation of ownership and management Transfer of ownership is easy
- Easier to raise capital
- Disadvantages
- Separation of ownership and management (agency problem)
- Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate, while dividends paid are not tax deductible)
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INTERNATIONAL CORPORATE FORMS
- Joint stock companies
- Public limited companies
- Limited liability companies
- All share:
- Public ownership
- Limited liability
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GOAL OF FINANCIAL MANAGEMENT
What should be the goal of a corporation?
- Maximize the current value per share of the company’s existing stock
- Maximize the market value of the existing owners’ equity
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SARBANES-OXLEY ACT
- Driven by corporate scandals
- Enron, Tyco, WorldCom, Adelphia
- Intended to strengthen protection against accounting fraud and financial malpractice
- Compliance very costly
- Firms driven to:
- Go public outside the U.S.
- Go private ("go dark")
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THE AGENCY PROBLEM
- Agency relationship
- Principal hires an agent to represent its interests
- Stockholders (principals) hire managers (agents) to run the company
- Agency problem
- Conflict of interest between principal and agent
- Management goals and agency costs
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DO MANAGERS ACT IN THE SHAREHOLDERS’ INTERESTS?
- Managerial compensation
- Incentives can be used to align management and stockholder interests
- Incentives need to be carefully structured to insure that they achieve their goal
- Corporate control
- Threat of a takeover may result in better management
- Other stakeholders
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FINANCIAL MARKETS
Cash flows to the firm
- Primary vs. secondary markets
- Dealer vs. auction markets
- Listed vs. over-the-counter securities
- NYSE
- NASDAQ 1
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THE BALANCE SHEET
- A snapshot of the firm’s assets and liabilities at a given point in time ("as of …)
- Assets
- −Left-hand side (or upper portion)
- −In order of decreasing liquidity
- Liabilities and Owners’ Equity
- Right-hand side (or lower portion)
- In ascending order of when due to be paid
- Balance Sheet Identity
- Assets = Liabilities + Stockholders’ Equity
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net working capital (balance sheet)
- current assets - current liabilities
- Usually positive for a healthy firm
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Liquidity (balance sheet)
- Speed and ease of conversion to cash without significan loss of value
- Valuable in avoiding financial distress
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Debt vs. equity (balance sheet)
Shareholders equity = assets - liabilities
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Book value
the balance sheet value of the assets, liabilities, and equity.
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Market value
true value; the price at which the assets, liabilities, or equity can actually be bought or sold.
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INCOME STATEMENT
- The income statement measures performance over a specified period of time (period, quarter, year).
- Report revenues first and then deduct any expenses for the period
- End result = Net Income = "Bottom Line"
- Dividends paid to shareholders
- Addition to retained earnings
- Income Statement Equation:
- •Net Income = Revenue - Expenses
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GAAP Matching Principle
- Recognize revenue when it is fully earned
- Match expenses required to generate revenue to the period of recognition
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Noncash Items
- Expenses charged against revenue that do not affect cash flow
- Depreciation = most important
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Time and Costs
- Fixed or variable costs
- Not obvious on income statement
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Earnings Management
- Smoothing earnings
- GAAP leaves "wiggle room" 2
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TAXES
Marginal vs. Average tax rates
- Marginal – % tax paid on the next dollar earned
- Average – total tax bill / taxable income
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CASH FLOW
- Cash flow = one of the most important pieces of information that can be derived from financial statements
- The accounting Statement of Cash Flows does not provide the same information that we are interested in here
- Our focus: how cash is generated from utilizing assets and how it is paid to those who finance the asset purchase.
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CASH FLOW FROM ASSETS
- Cash Flow From Assets (CFFA)
- = Operating Cash Flow (OCF)
- – Net Capital Spending (NCS)
- – Changes in NWC (ΔNWC)
- Cash Flow From Assets (CFFA)
- = Cash Flow to Creditors (CF/CR)
- + Cash Flow to Stockholders (CF/SH)
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OCF Operating cash flow (income statement)
- = EBIT + depreciation – taxes
- = $694 + 65 – 212 = $547
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NCS Net Capital Spending (Balance sheet & Income Statement)
- = ending net Fixed Assets (FA) – beginning net FA + depreciation
- = $1709 – 1644 + 65 = $130
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ΔNWC Change in Net Working Capital
= ending NWC (CA-CL 2012) – beginning NWC (CA-CL 2010) = ($1403 – 389) – ($1112 – 428) = $330
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CFFA Cash Flow from Assets
- CFFA = OCF – NCS - ΔNWC
- Cash Flow From Assets CFFA
- = Operating Cash Flow OCF
- - Net Capital Spending NCS
- - Change in Working Capital ΔNWC
- $87 = 547 – 130 – 330 = $87
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CF/CR Cash Flow to creditors
- = interest paid – net new borrowing
- = $70 – ($454 – 408) = $24
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CF/SH Cash Flow to Stockholders
- = dividends paid – net new equity
- = $103 – ($640 – 600) = $63
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CFFA = Cash Flow from Assets
- CFFA = CF/CR + CF/SH
- interest paid – net new borrowing
- + dividends paid – net new equity
- CFFA = $24 + $63 = $87
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The cash flow identity
- Cash flow from assets =
- cash flow to creditors (bondholders)
- + cash flow to stockholders (owners)
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Cash flow from assets
- Cash flow from assets =
- - Operating cash flow (EBIT+ Dep - Taxes)
- - Net capital spending (NCS)
- - change in net working capital (NWC).
Where
- Operating Cash flow = EBIT +dep - Taxes
- Net capital Spending = Ending net fixed assets - beginning net fixed assets + Dep
Change in NWC = Ending NWC - Beginning NWC
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Cash flow to creditors (Bondholders)
Cash flow to creditors = interest paid - net new borrowings
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Cash flow to stockholders (owners)
- Cash flow to stockholders =
- dividends paid - net new equity raised
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Common-Size Balance Sheets (standardized financial statement)
All accounts = percent of total assets (%TA)
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Common-Size Income Statements (standardized financial statement)
All line items = percent of sales or revenue (%SLS)
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Standardized statements are useful for:
- Comparing financial information year-to-year
- Comparing companies of different sizes, particularly within the same industry
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RATIO ANALYSIS
- Allow for better comparison through time or between companies
- Used both internally and externally
- For each ratio, ask yourself:
- What the ratio is trying to measure
- Why that information is important
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Quick Ratio
(CA – Inventory) / CL
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Total Debt Ratio
(TA – TE) / TA
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Equity Multiplier
TA/TE = 1 + D/E
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Times Interest Earned
EBIT / Interest
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EBIT / Interest
(EBIT + Deprec) / Interest
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Inventory Turnover
COGS / Inventory
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Days’ Sales in Inventory
COGS / Inventory turnover
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Receivables Turnover
Sales / AR
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Days’ Sales in Receivables
365 / Receivables Turnover
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Total Asset Turnover
Sales / Total Assets
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Capital Intensity Ratio
1/TAT
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Return on Assets (ROA)
NI/TA
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Return on Equity ROE
NI/TE
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Earnings Per Share EPS
NI/shares outstanding
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Price/Sales Ratio
PPS/Sales per share
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Market-to-book ratio
PPS / Book value per share
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The Dupont Identity
- ROE = NI / TE (basic formula)
- ROE = PM * TAT * EM (Dupont Idenity)
- PM = Net Income / Sales
- TAT = Sales / Total Assets
- EM = Total Assets / Total Equity
- ROE - NI/Sales x Sales/TA x TA/TE = NI/TE
- ROE= Profit Margin x Asset use x Leverage
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ROE = PM * TAT * EM
- Profit margin
- Measures firm’s operating efficiency
- How well does it control costs
- Total asset turnover
- Measures the firm’s asset use efficiency
- How well does it manage its assets
- Equity multiplier
- Measures the firm’s financial leverage
- EM = TA/TE = 1+D/E ratio 3
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Dividend payout ratio
cash dividends DIV / NI
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Retention ratio or Plowback ratio
Additions to retained earnings/NI
Must equal 1 between the dividend payout and the retention ratio.
If Retention ratio is 60% then the dividend payout ratio is 40% or 1-b (plowback)
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DETERMINANTS OF GROWTH
- Profit margin – operating efficiency
- Total asset turnover – asset use efficiency
- Financial leverage – choice of optimal debt ratio
- Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm
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PROBLEMS WITH FINANCIAL ANALYSIS
- Conglomerates
- No readily available comparables
- Global competitors
- Different accounting procedures
- Different fiscal year ends
- Differences in capital structure
- Seasonal variations and one-time events
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