Fin 101 ch 1-3

• 1. Corporate finance
• 2. Investments
• 3. Financial Institutions
• 4. International Finance

Business finance more applicable.

• 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

• Companies that specialize in financial matters
• Banks – commercial and investment, credit unions, savings and loans
• Insurance companies
• Brokerage firms

• 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

• 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?

• 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

What long-term investments or projects should the business take on?

• How should we pay for our assets?
• Should we use debt or equity?

How do we manage the day-to-day finances of the firm?

• 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

• 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

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)

• Joint stock companies
• Public limited companies
• Limited liability companies

• All share:
• Public ownership
• Limited liability

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

• 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")

• 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

• 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

Cash flows to the firm

• Primary vs. secondary markets
•    Dealer vs. auction markets  
•    Listed vs. over-the-counter securities
•        NYSE 
•        NASDAQ 1

• 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

• current assets - current liabilities
• Usually positive for a healthy firm

• Speed and ease of conversion to cash without significan loss of value
• Valuable in avoiding financial distress

Shareholders equity = assets - liabilities

the balance sheet value of the assets, liabilities, and equity.

true value; the price at which the assets, liabilities, or equity can actually be bought or sold.

• 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

• Recognize revenue when it is fully earned
• Match expenses required to generate revenue to the period of recognition

• Expenses charged against revenue that do not affect cash flow
• Depreciation = most important

• Fixed or variable costs
• Not obvious on income statement

• Smoothing earnings
• GAAP leaves "wiggle room" 2

•  Marginal – % tax paid on the next dollar earned
•  Average – total tax bill / taxable income

• 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.

• 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)

• = EBIT + depreciation – taxes
• = $694 + 65 – 212 = $547

• = ending net Fixed Assets (FA) – beginning net FA + depreciation
• = $1709 – 1644 + 65 = $130

= ending NWC (CA-CL 2012) – beginning NWC (CA-CL 2010) = ($1403 – 389) – ($1112 – 428) = $330

• 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

• = interest paid – net new borrowing
• = $70 – ($454 – 408) = $24

• = dividends paid – net new equity
• = $103 – ($640 – 600) = $63

• CFFA = CF/CR + CF/SH
• interest paid – net new borrowing
• + dividends paid – net new equity
•  CFFA = $24 + $63 = $87

• Cash flow from assets =
• cash flow to creditors (bondholders)
• + cash flow to stockholders (owners)

• 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

Cash flow to creditors = interest paid - net new borrowings

• Cash flow to stockholders =
• dividends paid - net new equity raised

All accounts = percent of total assets (%TA)

All line items = percent of sales or revenue (%SLS)

• Comparing financial information year-to-year
• Comparing companies of different sizes, particularly within the same industry

• 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

CA / CL

(CA – Inventory) / CL

Cash Ratio

(TA – TE) / TA

TD / TE

TA/TE = 1 + D/E

EBIT / Interest

(EBIT + Deprec) / Interest

COGS / Inventory

COGS / Inventory turnover

Sales / AR

365 / Receivables Turnover

Sales / Total Assets

1/TAT

NI/Sales

NI/TA

NI/TE

PPS / EPS

NI/shares outstanding

PPS/Sales per share

PPS / Book value per share

• 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

• 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

cash dividends DIV / NI

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)

• ROA x b/
• 1-ROA x b

• ROE x b/
• 1-ROE x b

• 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

• Conglomerates
• No readily available comparables
• Global competitors
• Different accounting procedures
• Different fiscal year ends
• Differences in capital structure
• Seasonal variations and one-time events