Thursday morning

Finance

What is Finance?

• Finance -- The function in a business that acquires funds for a firm and manages them within the firm.

• Finance activities include:

- Preparing budgets

- Creating cash flow analyses

- Planning for expenditures

Financial Management

• Financial Management -- The job of managing a firm’s resources to meet its goals and objectives.

What Financial Managers Do

Why Do Firms Fail Financially?

• Undercapitalization

• Poor control over cash flow

• Inadequate expense control

Who’s Who in Finance

• CFO -- Chief Financial Officer

• CFP -- Certified Financial Planner

• CFA -- Chartered Financial Analyst

• Controller -- Chief Accounting Officer

Financial Forecasting

• Short-Term Forecast -- Predicts revenues, costs and expenses for a period of one year or less.

• Cash-Flow Forecast -- Predicts the cash inflows and outflows in future periods, usually months or quarters.

• Long-Term Forecast -- Predicts revenues, costs, and expenses for a period longer than one year and sometimes as long as five or ten years.

Budgeting

• Budget -- Sets forth management’s expectations for revenues and allocates the use of specific resources throughout the firm.

• Budgets depend heavily on the balance sheet, income statement, statement of cash flows and short-term and long-term financial forecasts.

• The budget is the guide for financial operations and expected financial needs.

Types of Budgets

• Capital Budget -- Highlights a firm’s spending plans for major asset purchases that often require large sums of money.

• Cash Budget -- Estimates cash inflows and outflows during a particular period like a month or quarter.

• Operating (Master) Budget -- Ties together all the firm’s other budgets and summarizes its proposed financial activities.

Years Cash Flows

10% Factor

Present Value

Investment in equipment Now $ (160,000) 1.000 (160,000)$ Working capital needed Now (100,000) 1.000 (100,000) Annual net cash inflows 1-5 80,000 3.791 303,280 Relining of equipment 3 (30,000) 0.751 (22,530) Salvage value of equip. 5 5,000 0.621 3,105 Working capital released 5 100,000 0.621 62,100 Net present value 85,955$

Capital Budgeting Example

The Master Budget: An Overview

Production budget

Selling andadministrative

budget

Direct materialsbudget

Manufacturingoverhead budget

Direct laborbudget

Cash Budget

Sales budget

Ending inventorybudget

Budgetedbalance sheet

Budgetedincome

statement

The Cash Budget

Establishing Financial Control

• Financial Control -- A process in which a firm periodically compares its actual revenues, costs and expenses with its budget.

FACTORS USED in ASSESSING FINANCIAL CONTROL

• Is the firm meeting its short-term financial commitments? (current ratio/quick ratio)

• Is the firm producing adequate operating profits on its assets? (ROA)

• How is the firm financing its assets? (debt or equity)

• Are the firms owners receiving an acceptable return on their investment? (ROE/ROI)

WAYS to RAISE START-UP CAPITAL

• Seek out a microloan from a microlender

• Use asset-based lending or factoring

• Turn to the web and seek out peer-to-peer lending

• Research local banks

• Sweet-talk vendors you want to do business with

Sources of Capital• Personal savings

• Relatives

• Former employers

• Banks & finance companies

• Government agencies

• Venture capitalists -- Individuals or companies that invest in new businesses in exchange for partial ownership. (generally pooled funds professionally managed)

• Angel investors – use their own funds

• Super Angels

HOW SMALL BUSINESSES CAN IMPROVE CASH FLOW

• Be more aggressive in collecting accounts receivable.

• Offer customers discounts by paying early.

• Take advantage of special payment terms from vendors.

• Raise prices.

• Use credit cards discriminately.

ALTERNATIVE SOURCES of FUNDS

• Debt Financing -- The funds raised through various forms of borrowing that must be repaid.

• Equity Financing -- The funds raised from within the firm from operations or through the sale of ownership in the firm (such as stock).

SHORT and LONG-TERM FINANCING

• Short-Term Financing -- Funds needed for a year or less.

• Long-Term Financing -- Funds needed for more than a year.

Why Firms Need Financing

Short-Term Funds Long-Term Funds

Monthly expenses New-product development

Unanticipated emergencies Replacement of capital equipment

Cash flow problems Mergers or acquisitions

Expansion of current inventory Expansion into new markets

Temporary promotional programs New facilities

TYPES of SHORT-TERM FINANCING

• Trade Credit -- The practice of buying goods or services now and paying for them later.

• Businesses often get terms 2/10 net 30 when receiving trade credit.

• What is this really worth??

• Promissory Note -- A written contract agreeing to pay a supplier a specific sum of money at a definite time.

DIFFERENT FORMS of SHORT-TERM LOANS

• Commercial banks offer short-term loans like:

- Secured Loans -- Backed by collateral.

- Unsecured Loans -- Don’t require collateral from the borrower.

- Line of Credit -- A given amount of money the bank will provide so long as the funds are available.

- Lehman Brothers (repo market)

- New York Times video – Hartsko

- Grameen Bank

Factoring Your Accounts Receivable

• Selling your AR for cash

• Factor is an intermediary that buys a company’s AR, at a discount; and then collects the proceeds

• Amount of discount is based on age of receivables, strength of business

• Can be an expensive form of short-term financing

Commercial Paper

• Commercial Paper -- Unsecured promissory notes in amounts of $100,000+ that come due in 270 days or less.

• Since commercial paper is unsecured, only financially stable firms are able to sell it.

• Assists in financing of current assets and payment of current liabilities; cannot be used on long-term assets

SETTING LONG-TERM FINANCING OBJECTIVES

• Three questions of financial managers in setting long-term financing objectives:

1. What are the organization’s long-term goals and objectives?

2. What funds do we need to achieve the firm’s long-term goals and objectives?

3. What sources of long-term funding (capital) are available, and which will best fit our needs?

USING LONG-TERM DEBT FINANCING

• Long-term financing loans generally come due within 3 -7 years but may extend to 15 or 20 years.

• Term-Loan Agreement -- A promissory note that requires the borrower to repay the loan with interest in specified monthly or annual installments.

• A major advantage of debt financing is the interest the firm pays is tax deductible.

USING DEBT FINANCING by ISSUING BONDS

• Indenture Terms -- The terms of agreement in a bond issue.

• Secured Bond -- A bond issued with some form of collateral (i.e. real estate).

• Unsecured (Debenture) Bond -- A bond backed only by the reputation of the issuing company.

Securing Equity Financing

• A company can secure equity financing by:

- Selling shares of stock in the company.

- Earning profits and using the retained earnings as reinvestments in the firm.

- Attracting Venture Capital -- Money that is invested in new or emerging companies that some investors believe have great profit potential.

USING LEVERAGE for FUNDING NEEDS

• Leverage -- Raising funds through borrowing to increase the firm’s rate of return.

• Cost of Capital -- The rate of return a company must earn in order to meet the demands of its lenders and expectations of equity holders.

• ROA vs ROE Excel example

Securities Markets

• Securities markets are financial marketplaces for stocks and bonds and serve two primary functions:

1. Assist businesses in finding long-term funding to finance capital needs.

2. Provide private investors a place to buy and sell securities such as stocks and bonds.

TYPES of SECURITIES MARKETS

• Securities markets are divided into primary and secondary markets:

- Primary markets handle the sale of new securities.

- Secondary markets handle the trading of securities between investors with the proceeds of the sale going to the seller.

• Initial Public Offering (IPO) -- The first offering of a company’s stock. LinkedIn

INVESTMENT BANKERS and INSTITUTIONAL INVESTORS

• Investment Bankers -- Specialists who assist in the issue and sale of new securities. Goldman Sachs

• Institutional Investors -- Large organizations such as pension funds or mutual funds that invest their own funds or the funds of others. Vanguard, CALPERS

Stock Exchanges

• Stock Exchange -- An organization whose members can buy and sell securities on behalf of companies and individual investors.

• Over-the-Counter (OTC) Market -- Provides companies and investors with a means to trade stocks not listed on the national securities exchanges.

• NASDAQ -- A telecommunications network that links dealers across the nation so they can exchange securities.

The SEC

• Securities and Exchange Commission (SEC) -- The federal agency responsible for regulating the various stock exchanges; created in 1934 through the Securities and Exchange Act.

• Prospectus -- A detailed registration statement that includes extensive economic and financial information that must be sent to prospective investors.

The Language of Stocks

• Stocks -- Shares of ownership in a company.

• Stock Certificate -- Evidence of stock ownership.Apple

• Dividends -- Part of a firm’s profits that the firm may distribute to stockholders as either cash or additional shares.

Advantages of Issuing Stocks

• Stockholders are owners of a firm and never have to be repaid their investment.

• There’s no legal obligation to pay dividends.

• Issuing stock can improve a firm’s balance sheet since stock creates no debt.

Disadvantages of Issuing Stocks

• Stockholders have the right to vote for a company’s board of directors.

• Issuing new shares of stock can alter the control of the firm.

• Dividends are paid from after-tax profits and are not tax deductible. (double taxation)

• The need to keep stockholders happy can affect management’s decisions.

Two Classes of Stock

• Common Stock -- The most basic form; holders have the right to vote for the board of directors and share in the profits if dividends are approved.

• Preferred Stock -- Owners are given preference in the payment of company dividends before common stock dividends are distributed. Preferred stock can also be:

- Callable

- Convertible

- Cumulative

Key Stock Market Indicators

• Dow Jones Industrial Average -- The average cost of 30 selected industrial stocks.

• Critics say the 30-company Dow is too small a sample and suggest following the S&P 500.

• S&P 500 tracks the performance of 400 industrial, 40 financial, 40 public utility, and 20 transportation stocks.

Stock Splits

• Stock Splits -- An action by a company that gives stockholders two or more shares of additional stock for every share that’s outstanding.

• Splits cause no change in the firm’s ownership structure and no change in the investment’s value.

• Firms can never be forced to spilt their stocks.

• Berkshire Hathaway

UNDERSTANDING STOCK QUOTATIONS

Learning the Language of Bonds

• Bond -- A corporate certificate indicating that an investor has lent money to a firm.

• The principal is the face value of the bond.

• Interest -- The payment the bond issuer makes to the bondholders to compensate them for the use of their money.

• Understanding Bond Quotes

Advantages of Issuing Bonds

• Bondholders are creditors, not owners of the firm and can’t vote on corporate matters.

• Bond interest is tax deductible.

• Bonds are a temporary source of funding and are eventually repaid.

• Bonds can be repaid before the maturity date if they contain a call provision.

• Google, 2

Disadvantages of Issuing Bonds

• Bonds increase debt and can affect the market’s perception of the firm.

• Paying interest on bonds is a legal obligation.

• If interest isn’t paid, bondholders can take legal action.

• The face value of the bond must be repaid on the maturity date.

Bond Ratings

Rating

Moody’s Standard & Poor’s Description

Aaa AAA Highest Quality

Aa AA High Quality

A A Upper-Medium Grade

Baa BBB Medium Grade

Ba BB Lower-Medium Grade

B B Speculative

Caa CCC, CC Poor

Ca C Highly Speculative

C D Lowest Grade

DIFFERENT CLASSES of CORPORATE BONDS

• Unsecured bonds (debenture bonds): not backed by specific collateral.

• Secured bonds: backed by collateral (land or equipment).

DIFFERENCES BETWEEN DEBT and EQUITY FINANCING

Types of Financing

Conditions Debt Equity

Management influenceNone. Unless special conditions have been agreed on.

Common stock holders have voting rights.

RepaymentDebt has a maturity date.

Stock has no maturity date.

Yearly obligations Payment of interest.The firm isn’t legally liable to pay dividends.

Tax benefitsInterest is tax deductible.

Dividends are not tax deductible.

Investing in Mutual Funds

• Mutual Fund -- An organization the buys stocks and bonds and then sells shares in those securities to the public. The fund pools investors’ money and buys stocks according to the fund’s purpose.

• Enables investors to diversify their risks

Comparing Investments

AVERAGE ANNUAL RETURN of ASSET CLASSES (1926-2007)

Investment Return

Small company stocks 12.2%

Large company stocks 9.5%

Corporate bonds 6.0%

Long-term government bonds 5.8%

Treasury bills 4.1%

HOW to be a MILLIONAIREshould be HOW TO BE HAPPY!!

• Self-employed people are 5 times more likely to be millionaires.

• Millionaires studied tended to have modest homes and bought used cars.

• Millionaires are educated, work hard, save money and make purchases carefully.

• The Automatic Millionaire

• The Millionaire Next Door – seven rules

• Excel spreadsheet

FINANCIAL PLANNING BEGINS with MAKING MONEY

• An investment in education pays the best interest rate:

- A typical full-time worker with a four-year degree earns about $50,000, 62% more than a person with a high school diploma.

- The lifetime earnings of a family with bachelor’s degrees will be about $1.6 million more than a family with high school diplomas.

Six Steps to Control Your Finances

1. Take an inventory of your financial assets

2. Keep track of all your expenses

3. Prepare a budget

4. Pay off your debts

5. Start a savings plan

6. Borrow only to buy assets that increase in value.

BUILDING YOUR FINANCIAL BASE

• Live frugally. If married, try to live on one income.

• Your first major investment should be a low-priced home – yes vs no

• Buy for the long term and don’t live beyond your means.

• Contrarian advice??

Financial Benefits of Buying a Home

• A home is an investment you can live in.

• Paying for a home is a good way of forcing yourself to save.

• Interest paid on your home loan is tax deductible.

• Three keys to optimal return on your home are: location, location, location.

• Spreadsheet on mortgage

Life Insurance

• Term Insurance -- A pure insurance protection for a given number of years that typically costs less the younger you buy it. Get a quote

• Permanent Life Insurance -- Combines pure insurance with savings, so you buy both insurance and a savings plan.

• Whole, universal

• Variable Life Insurance -- A form of whole life insurance that invests the cash value of the policy in stocks or other high-yielding securities.

Retirement Planning

• Kiplinger – 5 best ways to save for retirement and 5 things to know about IRAs

• Social Security -- The Old-Age, Survivors, and Disability Insurance Program established by the Social Security Act of 1933.

• Social Security benefits are paid through social security taxes paid by workers currently earning wages in the market.

• The Social Security fund is expected to be hard pressed because of the growing number of older adults.

IRAs

• Individual Retirement Accounts (IRAs) -- Tax-deferred investment plans that enable a person to save part of their income for retirement.

• Tax-Deferred Contributions -- Contributions in which you pay no current taxes, but earnings gained in the IRA are taxed as income after withdrawal.

• Roth IRA -- Doesn’t give an up-front tax deduction but earnings grow tax-free and are tax-free when they are withdrawn.

401(k) Plans

• 401(k) Plan -- An employer-sponsored savings plan that allows you to deposit a set amount of pretax dollars and collect compounded earnings tax-free until withdrawal.

• Three benefits of 401(k) plans:

1. Contributions reduce your present taxable income

2. Tax is deferred on the earnings

3. Many employers will match your contributions.

1. VU – we put in 5%, they match 10%!!

Time Value of Money

• Future Value of a Lump Sum• Future Value of an Annuity• Present Value of a Lump Sum• Present Value of an Annuity