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Finance (FNCE 101)

IntroductionFinancial Statements

Chapters 1,2,3

Professor WANG Rong

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Today’s Agenda Discussion of Syllabus Introduction to Finance (Chapter 1)

Business forms Financial managers Agency problems Financial markets

Financial Statements (Chapters 2,3)

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Course Objectives Introduce the key concepts of Finance Evaluate Investment Projects Value Bonds and Stocks Analyze Risk and Return Estimate Costs of Capital Capital Structure Options Help with Personal Finance

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Course ReadingsTextbook

•Fundamentals of Corporate Finance, by Ross, Westerfield, Jordan, Lim and Tan (Asia Global Edition)

•You can also use “Corporate Finance Fundamentals”, by Ross, Westerfield and Jordan, 8th/9th edition.

Lecture notes•Available at eLearn

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Course Grading Class participation (name card): 10% Group Project

Oral Presentation: 5% Written Report: 15%

Quizzes (Two): 10% Midterm Exam: 20% Final Exam: 40%

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Course Structure - I Homework Assignments:

will not be graded, but everyone should do

Class Participation (Name Card) Good behavior:

ask questions (including Q&A after student presentations) answer questions, help solving problems

Bad behavior: surf internet chat SMS, etc.

Computer policy

Course Structure - II Quizzes

Two quizzes, 20 minutes, about 10 MCQs Closed book, closed notes, basic formulas will be

provided Calculators are allowed. Cell phones are not allowed.

No makeups. If you are unable to take quizzes due to a serious health

problem (with MC), the first quiz (the second quiz) will be cumulated to your midterm (final exam).

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Course Structure - III Midterm

21 Feb 2012, Friday 6pm – 7:30pm Closed-book, closed-notes, formulas will be provided. Calculators are allowed. Cell phones are not allowed. No make-ups. If you miss the midterm exam due to a health

problem (with MC), your midterm will be cumulated to your final grade.

If you have a time conflict, inform me no later than the 2nd week.

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Course Structure - IV

Final Exam April 23th, 13PM-15PM Cumulative, Closed-book, closed-notes, 2 hours Formulas will be provided. Calculators are allowed. Cell phones are not

allowed.

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Group Project - I The project is about in-depth analysis on a firm’s financial

health, emphasizing risk-return tradeoffs and valuation. Details are posted on eLearn.

Groups will be assigned randomly and announced in week 5.

Each group needs to pick a listed (public) firm and email me and your TA the company picked by the end of week 8.

To ensure that every group picks a different company, we follow a first-come first-serve system. For those who fail to meet the deadline, a randomly selected company will be assigned to you. After the deadline, no further changes will be allowed.

Group Project - II Suggestions on how to select a company:

A listed firm (SGX, NYSE, NASDAQ…) A large firm with with easy access to financial information

(and preferably with regular dividend payments) Mainly focus on one industry, and easy to find competitors

in the same industry (and in the same country). Some examples: Coca Cola, Starwood Hotels and Resorts,

IBM, Coach Inc., Ralph Lauren, Whole Foods Market, TripAdvisor.

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Group Project - III Grading (20% of final grade)

Oral presentation (week 12&13): 5 points. 20-minute presentation + 5-minute Q&A Everybody should present. Members in a group may receive

different grades based on their own performance. Week 12 – Groups 1-5; Week 13 – Groups 6-9

Written report (due in class of week 12 for ALL groups): 15 points.

Maximum 20 pages (excluding appendix) Late submission will be punished by 5 points. Members in a group by default get same grade for the written

report. However if someone has very little contribution, he/she will receive lower grade than others.

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Financial Calculator Examples: HP-10B, Sharp EL-733A, and

Texas Instruments BA II Plus

In class, I will use Texas Instruments BA II Plus for illustration

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Teaching Assistants G4 (Mon, SR2.8) - Daphne KOK Yuen Wah

daphne.kok.2011@economics.smu.edu.sg

G5 (Tue, SR2.7) - CHUAH Chia Ern cechuah.2011@business.smu.edu.sg

G6 (Wed, SR3.2) - LY Phuong Dung pdly.2011@business.smu.edu.sg

G7 (Thu, SR2.7) - Veronica KUOH Jia Hui jhkuoh.2011@economics.smu.edu.sg

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My Expectations Preparation for class Class Participation Missed Work Honor Code Hint: If you don’t understand something,

ask me a question!

Preliminary Schedule – see syllabus

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Your Expectations of Me Your questions will be answered! Course Materials on eLearn Availability

Office: LKCSB Rm 4042

Email: rongwang@smu.edu.sg

Phone: 6828 0148 Office hours: By appointment. I will announce

office hours before exams.

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What is Finance? Finance studies and addresses the ways in which

individuals, business, and organizations raise, allocate, and use monetary resources over time, taking into account the risks entailed in their projects. (from Wikipedia)

Basic areas in Finance Corporate Finance Investments – work with financial assets Financial institutions International Finance

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What is corporate finance?

Corporate finance is about corporations’ financial decisions. What is a corporation?

A form of business organization Other forms of business organization also exist.

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One person owns the business

What businesses are likely to be sole proprietorships? What should be the goal of a sole proprietorship? Who gets to determine the goal?

1.2.3.

Advantages Disadvantages

1.2.34.

Least regulatedOwner keeps all

profitsLess agency issues

Unlimited liabilityHard ownership transferLimited life of business

Business Forms: Sole Proprietorship

Limited capital

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Two or more own the business

What businesses are likely to be partnerships? What should be the goal of a partnership? Who gets to determine the goal?

1.2.3.

Advantages Disadvantages

1.2.3.

Similar to sole proprietorship

Business Forms: Partnership

Similar to sole proprietorship

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Business owned by stockholders

What businesses are likely to be corporations? What should be the goal of a corporation? Who gets to determine the goal?

1.2.3.

Advantages Disadvantages

1.2.3.

Easier to raise moneyLimited liabilityEasy ownership transfer

Double taxationAgency issuesComplex regulation

Business Forms: Corporation

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Google, Inc. (founded 1998) provides Web search and online advertising services. Market capitalization: US$154B in 2008.

Asia Pacific Breweries (founded 1931, listed on the Singapore Exchange) is one of the key players in the beer industry. Today, APB oversees a portfolio of over 40 beer brands and brand variants, including Tiger Beer, Heineken, Anchor and ABC Stout. Market capitalization: SG$3.9B in 2006.

Question: Which is the largest company listed on the Singapore Exchange?

Valuation: Is it magic?

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Separation of Ownership and Control

Shareholders

Board of Directors

Management

Other Stakeholders

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Financial Manager

The top financial manager within a corporation is usually the Chief Financial Officer (CFO) Treasurer – responsible for cash management,

raising capital, and banking relationships Controller – responsible for budgeting,

accounting, and taxes

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Financial Management Decisions

Financing/capital structure decisions How much capital to raise? Debt vs. equity

Investment/capital budgeting decisions What projects to invest in?

Working capital management Short-term assets and short-term liabilities

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Objective of the Financial Manager

What is the basic goal of financial management? Minimize costs? Maximize market share? Avoid bankruptcy/survive as long as possible? Maximize profit? Maximize shareholder value?

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Agency Problems

Do managers really maximize shareholder wealth?

“Agency Problems” represent the conflict of interest between management and shareholders. Managers do not always act in the best interests

of shareholders, and they sometimes make decisions that destroy shareholder value.

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Solutions to Agency Problems

Monitoring The Board of Directors & Lenders & Speicalists

Compensation Plans stock and options

Takeovers

Legal and Regulatory Requirements

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Corporate Scandals & SOX WorldCom – 2001

Report $3.8 billion of operating expenses as investments and overstated the income.

Assets: 103.9 Billion Enron – 2001

Concealed $1.7 billion losses Assets: 65.5 Billion

Sarbanes-Oxley Act of 2002 the Public Company Accounting Reform and Investor

Protection Act of 2002 What is the largest bankruptcy in the world?

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Flow of Cash Between the Firm and the Financial Markets

Financial

Manager

Firm's

operations

Financial Markets

(Investors)

(1) Money raised from investors (2) Money invested in firm to buy real assets(3) Money generated by real assets(4a) Money reinvested(4b) Money returned to investors

(1)(2)

(3)

(4a)

(4b)

Financial Markets Primary market

A market where the firm sells its securities to public for the first time

Secondary markets A market in which the securities issued by firms are

traded Auction Markets (a physical location): Listed

securities trade in an organized exchange, e.g. NYSE Dealer markets (OTC, Over-the-counter): securities

are bought from or sold to a dealer (NASDAQ)

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Financial Statements

Chapter 2,3

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Major Financial Statements

Balance Sheet Income Statement Statement of Cash Flows (not covered)

Statement of the sources & uses of cash Operating Activities Investing Activities Financing Activities

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The Balance Sheet

The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time.

Assets are listed in order of liquidity Ease of conversion to cash Without significant loss of value

Balance Sheet Identity Assets = Liabilities + Stockholders’ Equity Stockholders’ Equity = Assets – Liabilities

(shareholders are “residual” owners)

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The Balance Sheet

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Income Statement The income statement is more like a video of the

firm’s operations for a specified period of time. Income Statement Identity

Net Income = Revenues - Expenses Matching principle – show revenue when it

accrues and match the expenses required to generate the revenue

How is balance sheet and income statement linked to each other?

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US Corporation Income Statement

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U.S. Corporate Tax Rates (progressive tax rates)

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Example: Marginal Vs. Average Rates

Marginal vs. average tax rates Marginal – the percentage paid on the next dollar earned Average – the tax bill / taxable income

Suppose your firm earns $200,000 in taxable income. What is the firm’s tax liability? What is the marginal tax rate? What is the average tax rate?

If you are considering a project that will increase the firm’s taxable income by $100,000, what tax rate should you use in your analysis?

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Singapore Corporate Tax Rate

Flat tax rate on income It’s going down!Year Tax rate Year Tax rate

1986 and before

40% 2001 25.5%

1987-1989 33% 2002 24.5%

1990 32% 2003-2004 22%

1991-1992 31% 2005-2007 20%

1993 30% 2008-2009 18%

1994-1996 27% 2010-2013 17%

1997-2000 26%

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Financial Statement Analysis – Ratio Analysis (I)

Ratios provide relative measures to interpret firm performance (strength and weakness).

There are five categories of ratios. Each category measure a different dimension of a firm’s performance (i.e. strengths & weaknesses).

1. Liquidity

2. Solvency or Leverage

3. Asset Management or Turnover

4. Profitability

5. Market value

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Category 1: Liquidity Ratios

What do they measure: How well can the firm pay its bills without undue stress. A high ratio indicates liquid, but too high may mean the

firm is inefficient.

Examples: Current ratio= Current assets / Current liabilities

Quick ratio = (Current assets – Inventory) / Current liabilities

Cash ratio = Cash / Current liabilities

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Category 2: Solvency (Leverage) Ratios

What do they measure? Measures the firms long-run ability to meet its

obligations. Too high of a ratio could lead to financial distress Too low of a ratio could indicate the firm is not

utilizing all the benefits of debt.

Examples: Total debt ratio = (Total assets – Total equity) / Total

assets

Equity multiplier = Total assets / Total equity

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Category 3: Asset Management and Turnover Ratios

What do they measure? How efficiently does the firm use its assets to generate

sales Investigates long-term and current assets.

Examples: Inventory turnover = Cost of goods sold/ Inventory

Total asset turnover = Sales / Total assets

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Category 4: Profitability Ratios

What do they measure? They show how well the firm is able to control expenses

and generate revenue (the difference being profits).

Examples: Profit margin = Net income/ Sales

Return on assets (ROA) = Net income/Total assets Return on equity (ROE) = Net income/Total equity

Du Pont IdentityROE =Net Income/Total Equity

=(NI/Sales)*(Sales/Assets)*(Assets/Total Equity)

=Profit margin*Assets Turnover*Equity Multiplier

Du Pont Identity tells us that that ROE is affected by three things:Operating efficiency (as measured by profit margin)– how well it controls costsAsset use efficiency (as measured by total asset turnover) – how well does it manage its assetsFinancial leverage (as measured by the equity multiplier)

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Category 5: Market value ratios

What do they measure? They tell us a firm’s market value relative to its

accounting measure.

Examples: PE ratio=price per share/earnings per share Market to Book ratio = market value per

share / book value per share

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What is the market value of a firm?

How do we measure Value? Book Value (BV) Market Value (MV)! BV is based on historical cost of assets. MV measures current value of assets and

liabilities MV is forward looking, it reflects a firm’s

potential growth.

What is the market value of a firm?

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Homework Assignments Read syllabus, the group project description,

chapters 1,2,3

Supplemental Readings IBM_Annual_report_1994 Basic Accounting Glossary

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Next Class Financial Tools – Chapters 5,6 Name Card Get a Financial calculator. Before the class,

Set the number of decimal places to four or higher

Set P/Y (which means number of payments per year) to one.

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Texas Instruments BA II Plus

Procedure: Changing the Number of Decimal Places Press 2nd FORMAT DEC= is displayed with the current

decimal-place setting. Enter the number of decimal places to be displayed (0

through 9) and press ENTER. To return to the standard-calculator mode, press 2nd QuitProcedure: Setting P/Y = 1 Press 2nd P/Y , then enter 1 and press ENTER. To return to the standard-calculator mode, press 2nd Quit.