1© 2008 Thomson South-Western

Practical Financial Management,

5e

by William R. Lasher

Slides by

Bob Zaffram

Erie Community College

2© 2008 Thomson South-Western

Chapter 1

Foundations

3

An Overview of Finance

Investments and financial markets

Financial management of corporations

○ Fields are separate but related

4

Financial Assets

Real asset—an object that provides a service, such as a house, car, art, coin…

Financial asset—a document representing a claim to future income

○ Stock represents ownership interest

○ Bond represents a debt relationship

Investing involves buying financial assets in the hope of earning more money (a return)

○ Investments can be made directly or indirectly through a mutual fund

A Security is a financial asset that can be traded among investors

5

Financial Markets

Financial assets, issued by corporations

to raise money, are bought by investors

in financial markets

○ A framework or organization in which

people can buy/sell securities• Best known financial market is

the stock market

– Stock exchange at center

• Stockbroker is licensed to trade

securities

6

Simplified Financial System

Figure 1.1

7

Raising Money

The most common use of the word finance involves raising money to acquire assets

Forms of Financing

○ Issuing stock - equity financing

○ Borrowing money - debt financing• Bank

• Issuing bonds

• Leasing is like borrowing

○ Internal financing - retaining earnings

8

Raising Money

The field of finance deals with both

raising and investing money, but:

Changing Focus of Finance

○ Past - finance was limited to

financial market activity

○ Now - it includes:

• Goals and activities of investors: Portfolios

• The financial management of organizations

9

Financial Management

The management and control of money

and money-related operations within a

business

CFO – Chief Financial Officer

○ Executive in charge of finance

department

10

Financial Management

Functions of the finance department:

○ Keeping records

○ Receiving payments from customers

○ Making payments to suppliers

○ Borrowing funds

○ Purchasing assets

○ Selling stock

○ Paying dividends

○ Analysis of business decisions

○ Oversight of other departments

11

Business Decisions

Finance department provides analyses to:○ Determine which assets are purchased

• Acquiring another firm

• Expanding operations

○ Decide how those assets are financed• Equity

• Debt

Oversight○ Finance department oversees how

other departments spend money

12

The Price of Securities—A Link

Between the Firm and the Market

Two sides of finance – investments and financial management – connected since firms sell securities to investors in financial markets

Investors buy securities for the future cash flows expected from them

Link between company management and investors comes from this relationship between price and expected financial results

13

Finance and Accounting

Accounting○ System of record-

keeping designed to portray a firm‘s operations in a fair/unbiased manner

○ Generate financial statements which are provided to the marketplace

Finance○ Process of decision-

making related to raising money, analyzing results

○ Use the outputgenerated by accountants as inputs in finance

14

Finance and Accounting

Finance department generally consists

of both the accounting and treasury

departments

○ Controller is in charge of the

accounting department

○ Treasury department deals with

other financial activities

15

Finance Department Organization

Figure 1.2

16

The Importance of Cash Flow

Accounting creates

statements that are

designed to portray

what is physically

occurring in

numbers

Finance is concerned

with current and

future cash flow

In finance:

Cash is King

17

The Importance of Cash Flow

Q: Example: In 1999 we purchased a $1,000 asset that will be depreciated over five years using straight-line depreciation. Explain how that asset will be viewed from both an accounting and finance viewpoint.

A: Accounting: The initial cost of the asset of $1,000 will be reflected on the books as will the $200 annual depreciation.

Finance: We are interested in the $1,000 cash outflow and the taxes saved from the depreciation deduction—not the depreciation itself.

Exam

ple

18

The Language of Finance

Accounting is the language of finance

○ Finance professionals need some accounting knowledge

• Level of accounting knowledge depends on job

– Financial analyst needs to know LOTS of accounting

– Stockbrokers do not need as much

19

Financial Theory—The Relationship

with Economics

Modern financial theory began as a

branch of economics in the 1950s

○ Originally called ―financial economics‖

Today finance is a separate field

20

The Influence of Accounting, Economics and

Financial Theory on Financial Management

Figure 1.3

21

Forms of Business Organization

and Their Financial Impact

Businesses can be legally or organized as○ A sole proprietorship

○ A partnership

○ A corporation

Legal organization has an impact on○ Raising money

○ Taxation

○ Financial liability

For financial purposes combine partner/proprietor

22

The Proprietorship Form

Easy to start

Taxes○ Profit is taxed as personal income

• Taxed only once

Raising money○ If going outside the firm, a proprietorship must

obtain a loan• Lending money to a new business is risky

– Best outcome: repayment of principal and interest

– Worst outcome: lose everything

– Most new businesses fail

• Result: Collateral required

23

The Corporate Form

Getting started

○ Requires a legal incorporation process

• Takes time, work and money

Taxes

○ Double taxation

• Corporation pays corporate taxes on income

• Dividends paid to owners are taxed as

personal income

24

The Corporate Form

Example 1.1

Q: Ruth Samson owns a business that earns $100,000 before taxes. She wants to take the earnings home and spend them on herself. Assume a simplified tax system in which the rates are 34% for corporations and 30% for individuals with tax on dividends capped at 15%. Compare the total tax bills under the sole proprietorship and corporate forms of organization.

A: Corporate Proprietor

Pretax earnings $100,000 $100,000

Corporate tax (34%) 34,000 -

Earnings/dividend $ 66,000 $100,000

Personal tax (15%, 30%) 9,900 30,000

Net $ 56,100 $ 70,000

Exam

ple

25

The Corporate Form

Raising Money

○ Borrowing– Same issues faced by sole proprietorship

○ BUT the entrepreneur can now offer

stock (equity) to investors– If sell less than 50% can maintain control

○ From the investor‘s perspective– Stock is a risky investment but the reward may be worth it

» Worst possible outcome: may lose the investment

» Best possible outcome: may get rich

26

The Truth About

Limited Liability

Limited liability states that a stockholder is not liable for a corporation‘s debts○ Implies that the most a stockholder can lose is 100%

of his investment in the stock

○ True for owners not involved in the business

However, for owner operated small businesses○ Personal guarantees make entrepreneurs liable for

loans made to their business

○ Legal system holds individuals liable for negligence

○ These destroy the value of limited liability

27

S-Type Corporations and LLCs

Major advantage: Treated as a partnership

with respect to federal income taxes

○ LLC is replacing S-type

Government encourages formation of small

businesses because they create jobs

○ S-type corporations and LLCs

• Let small businesses avoid double taxation

• Offer limited liability

• Offer the ability to sell stock to raise money

28

Goals of Management

Economics—goal is to maximize profit○ Runs into short/long run problems

○ What about R&D?

Finance—goal is to maximize stockholders‘ wealth by maximizing stock price○ Bypasses the concern of whether the short-term or

long-term is more important, because stock price set in the financial market incorporates both!

29

Stakeholders and

Conflicts of Interest

Stakeholders that have an interest in the way

the firm is operated include:

Stockholders

Employees

Customers

Community

Management

Creditors

Suppliers

30

Conflicts of Interest

An Illustration

Example: Employees want management to build an athletic facility on corporate grounds○ Benefit—more effective employees (feel better,

happier, therefore more productive)

○ Cost—will come from profits that belong to stockholders

○ Represents a conflict of interest between stockholders and employees

○ What if the request was for healthier working conditions?

31

Management—A Privileged

Stakeholder Group

Ownership of a widely held company is very dispersed so no one has enough control to influence/remove management

Allows top management to become entrenched in positions controlling large amounts of resources

Management can use resources for their own benefit

32

The Agency Problem

Conflict of interest between stockholders and management○ Agent is hired by a principal and given decision-making authority

The Abuse of Agency○ Privileges and luxuries provided to executives - ‗perks‘

Controlling the Agency Problem○ Manage the agency problem by:

• Monitoring management (audits)

• Tying executive compensation to stock performance

33

Creditors Versus Stockholders—A

Financially Important Conflict of Interest

Creditor - anyone owed money by a business

including lenders, vendors, employees, or the

government

If actions of the borrowing firm become

riskier than before loan, creditors/lenders

are subject to more risk

○ But risk taking rewards all go to stockholders

Lenders put clauses in loan agreements to

prevent this