Presentation 1 Finance 101

Presentation 1Finance 101

BUAD 340

Overview

1. What is finance?

2. Three types of business organizations

3. The goal of the financial manager

4. The eight basic principles of finance

What is Finance?

Finance is the study of how people and businesses evaluate investments and raise capital to fund them. (how to get and use money)

ADCF 310/Fall2018/Week 1/Dr. Minor 3

Three Questions Addressed by the Study of Finance

What long-term investments should the firm

undertake? (capital budgeting decisions - how

to spend the money)

How should the firm fund these investments?

(capital structure

decisions - how to get the money)

How can the firm best manage its cash flows as

they arise in its day-to-day operations? (working capital

management decisions)


ADCF 310/Fall2018/Week 1/Dr. Minor

• At the macro level, finance is the study of financial institutions and financial markets and how they operate within the financial system in both the American and global economies.

• At the micro level, finance is the study of financial planning, asset management, and fund raising for business and financial institutions

What is finance?

Chapter 1, Liuren Wu

• Financial Services – Design and delivery of advice and financial products

to individuals, businesses, and government

• Managerial Finance– Duties of the financial manager

What is finance? (con’t)


1. Sole proprietorships

2. Partnerships

3. Corporations

Three types of business organizations

Hybrids


• It is a business owned by a single individual that is entitled to all the firm’s profits and is responsible for all the firm’s debt.

• There is no separation between the business and the owner when it comes to debts or being sued.

• Sole proprietorships are generally financed by personal loans from family and friends and business loans from banks.

• Advantages:– Easy to start– No need to consult others while making decisions– Taxed at the personal tax rate

• Disadvantages:– Personally liable for the business debts– Ceases on the death of the proprietor

Sole Proprietorship


• 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.

• There is no separation between the partnership and the owners with respect to debts or being sued.

• Advantages:– Relatively easy to start– Taxed at the personal tax rate– Access to funds from multiple sources or partners

• Disadvantages:– Partners jointly share unlimited liability

Partnership


• In limited partnerships, there are two classes of partners: general and limited.

• The general partners runs the business and face liability for the firm’s debts, while the limited partners are only liable on the amount invested.

• One of the drawback of this form is that it is difficult to transfer the ownership of the general partner.

Limited Partnership


Corporation


Corporation is “an artificial being, invisible, intangible, and existing only in the contemplation of the law.”

Corporation can individually sue and be sued, purchase, sell or own property, and its personnel are subject to criminal punishment for crimes committed in the name of the corporation.

Corporation is legally owned by its current stockholders.

The Board of directors are elected by the firm’s shareholders. One responsibility of the board of directors is to appoint the senior management of the firm.

1.2 Ownership

versus Control

of Corporations

• Corporate Management Team

– In a corporation, ownership and direct control are typically separate.

– Board of Directors• Elected by shareholders• Have ultimate decision-making

authority

– Chief Executive Officer (CEO)• Board typically delegates day-

to-day decision making to CEO.

1.2 Ownership

versus Control

of Corporations

(cont'd)

• Ownership and Control

– In a corporation, there may be thousands of shareholders, many with different priorities.

– Even if all of the shareholders agree on the goals of the firm, the goals must be implemented. This is the job of the management team.

– How can the shareholders be sure that the management team will implement their goals?

1.2 Ownership

versus Control

of Corporations

(cont'd)

• Principal-Agent Problem

– Managers may act in their own interest rather than in the best interest of the shareholders.

– One potential solution is to tie management’s compensation to firm performance.

– How should performance be measured?

1.2 Ownership

versus Control

of Corporations

(cont'd)

• CEO Performance

– If a CEO is performing poorly, shareholders can express their dissatisfaction by selling their shares. This selling pressure will drive the stock price down.

– Hostile Takeover• Low stock prices may entice a

Corporate Raider to buy enough stock so they have enough control to replace current management. The stock price will rise after the new management team “fixes” the company.

1.2 Ownership

versus Control

of Corporations

(cont'd)

• Corporate Bankruptcy

– Reorganization

– Liquidation

Corporation (con’t)


AdvantagesLiability of owners limited to invested fundsLife of corporation is not tied to the ownerEasier to transfer ownershipEasier to raise Capital

Disadvantages Greater regulation Double taxation of dividends

Corporation• Raising Money

– Borrowing– Same issues faced by sole proprietorship

– BUT owner 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: lose entire investment» Best possible outcome: get rich 19


Concept Connection Example 1-2 Tax Consequences of Business Form

A business earns $100,000 before taxes. Owner wants to take the earnings home. Tax rates: Corporate - 34% (now 21%)

Personal - 30% (now new rates)Compare total tax bills under corporate and proprietorship forms of organization


https://taxfoundation.org/2018-tax-brackets/

Example 1.1

Example 1.1 (cont'd)

• These organizational forms provide a cross between a partnership and a corporation.

• Limited liability company (LLC) combines the tax benefits of a partnership (no double taxation of earnings) and limited liability benefit of corporation (the owner’s liability is limited to what they invest).

• S-type corporation provides limited liability while allowing the business owners to be taxed as if they were a partnership – that is, distributions back to the owners are not taxed twice as is the case with dividends in the standard corporate form.

Hybrid Organizations


Figure 1.1 Types of U.S. Firms

ADCF 310/Fall2018/Week 1/Dr. Minor 1-25

• The goal of the financial manager must be consistent with the mission of the corporation to maximize firm shareholder’s wealth (as measured by share prices).

• While managers have to cater to all the stakeholders (such as consumers, employees, suppliers, etc.), they need to pay particular attention to the owners of the corporation, i.e., shareholders.

• If managers fail to pursue shareholder wealth maximization, they will lose the support of investors and lenders. The business may cease to exist and ultimately, the managers will lose their jobs!

The goal of the financial manager


Conflicts of Interest An Illustration

• Employees want management to build a gym • Benefit — healthy employees are more productive• Cost — reduces stockholders’ return

• Conflict of interest between stockholders and employees• What if request for healthier working conditions?


How to Reduce Agency

Problems?

• Monitoring• (Examples: Reports, Meetings,

Auditors, board of directors, financial markets, bankers, credit agencies)

• Compensation plans• (Examples: Performance based bonus,

salary, stock options, benefits)• Others

• (Examples: Threat of being fired, Threat of takeovers, Stock market, regulations such as SOX)

• The above will help to reduce agency problems/costs.

• “To achieve sustainable growth, we have established a vision with clear goals: maximizing return to shareholders while being mindful of our overall responsibilities.” – part of Coca-Cola’s mission statement

• “Our final responsibility is to our stockholders...when we operate according to these principles, the stockholders should realize a fair return.” – part of Johnson & Johnson’s credo

• “Optimize for the long-term rather than trying to produce smooth earnings for each quarter.” - Google

Corporate mission statements: examples


Accounting and FinanceBroad Portrayal vs. Cash Flow

• Accounting statements portray physical activity in numbers

• Descriptive • Historical

• E.g. Depreciation

• The focus in Finance is on future cash flow

• In finance: Cash is King

30


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

31


Figure 1-2 Finance Department Organization

32


How Does Finance Fit into the Firm’s Organizational Structure?

• In a corporation, the Chief Financial Officer (CFO) is responsible for managing the firm’s financial affairs.

• Figure 1-2 shows how the finance function fits into a firm’s organizational chart.


Concept Connection Example 1-1 Accounting Records and Cash Flow

35

A $1,000 asset depreciated straight-line over five years:

Accounting perspective – Portrait Over TimeInitial $1,000 cost becomes an asset on books$200 per year depreciation reduces profitBook value shrinks as depreciation accumulates

Finance perspective – Focus On Cash FlowDepreciation deduction saves cash by reducing taxIt took a $1,000 cash outflow to acquire the asset

Where did the money come fromFinance had to raise that money


The Language of Finance

• Accounting is the language of finance

• All finance professionals need some knowledge of accounting

• Level depends on job• Financial analyst needs

to know LOTS of accounting

• Stockbrokers not as much


Financial Theory—The Relationship with Economics

• Modern financial theory began as a branch of economics in the 1950s

• Originally called “financial economics”• Theoretical tools are very similar

• Finance is a separate but still related field

37


Figure 1-3 The Influence of Accounting, Economics and Financial Theory on Financial Management

38


Eight Principles of FinanceHandout


Presentation 1 Finance 101

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