entrepreneurial finance fifth edition

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Entrepreneurial Finance, 5th EditionAdelman and Marks 1-1

Pearson Higher Education©2010 by Pearson Education, Inc.Upper Saddle River, NJ 07458

ENTREPRENEURIAL FINANCEFifth Edition

Chapter 1Financial and Economic Concepts

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Buffett and Gates

Buffett and Gates Section 5

http://www.youtube.com/watch?feature=player_detailpage&v=_4_jj843x2Q Buffett and Gates Section 6

http://www.youtube.com/watch?feature=player_detailpage&v=_4_jj843x2Q Buffett and Gates Section 7

http://www.youtube.com/watch?feature=player_detailpage&v=g3e3RFx0D_c Buffett and Gates Section 8

http://www.youtube.com/watch?feature=player_detailpage&v=Ez_pjiIy0sY

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What is it?

Finance is essentially any transaction in which money or a money- like instrument is exchanged for other money or another money- like instrument.

Tasks› Cash management› Investing› Financing› Implementation of strategic plans

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Cash Management Critical task for managers Obviously need cash to operate Cannot exist very long with poor cash management What do we manage

› Inflow of cash

– From customers

– From investors› Outflow of cash

– To suppliers

– To creditors

– To owners

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Investing

Managers invest in two basic asset types› Invest in the securities of other companies

– Strategies followed are identical to the strategies of individual investors

› Invest in plant and equipment

– Processes are very similar to individuals

– Ultimate goal is to maximize the value of the firm

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Financing

Where do managers get funds to enable the firm to grow and operate.

Sources of funds› Their own assets› Friends, family, other people› Banks and insurance companies› Bonds› Stocks› Profits of the firm

The size and type of the firm will determine which of these can be used.

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Source: www.bizstats.com

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Implementation of the strategic plan

The overall outcome of financial management is to provide the mechanism and tools to implement the plans of the company.

A secondary activity is providing data for understanding how the plan is functioning. Also, data for the creation of the plan is provided through the tools available from financial management.

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Economic concepts

In the US, basic principle is that individuals can achieve their own objectives within a free enterprise system.

Market economy – individuals and institutions exchange goods and services freely› Real estate› Retail› Commodities› Financial instruments

Who gains when we perform transactions?› Both sides (buyers and sellers) believe they gain from a

transaction.

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Economic Concepts

Scarce resources – scarce because people want more than they have.

Types› Natural resources› Human resources› Capital resources

– Economic– Financial

› Entrepreneurial resources

http://www.youtube.com/watch?feature=player_detailpage&v=VttAbSYYIsw

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Economic Concepts Opportunity costs

› The highest value that is surrendered when a decision to invest funds is made.

http://www.youtube.com/watch?feature=player_detailpage&v=pWE7WDZC-lQ

Table 1-1 Expected Financial Returns of Investment Opportunity

Investment Opportunity Expected Annual Return (%)

Purchase stock 11

Purchase home 9

Purchase bonds 6

Place money in bank savings account 2

Purchase new car -15

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Income, Expenditures, and Taxes

Gross income is all of the money received from all sources during the year.› Wages› Tips› Interest earned on savings and bonds› Income from rental property› Profits to entrepreneurs

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Taxes

Progressive taxes: larger percentage of tax paid as income increases.

Regressive taxes: larger percentage of tax paid as income decreases.

Proportional taxes: percentage of tax paid remains the same at all levels of income.

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Example of Progressive Tax

100 x dollarsin Income

dollarsin payment Tax PercentageTax

Formula for tax percentage paid:

15% 100 x $20,000

$3,000 percentageTax

28% 100 x $60,000


Income tax is progressive:

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Example of Regressive Tax

5% 100x $20,000


1.667% 100 x $60,000


Sales tax is regressive:› Income = $20,000; savings = 0; sales tax = 5%› Sales tax paid = $20,000 x 0.05 = 1,000

› Income = $60,000; savings = $10,000; sales tax = 5%› Sales tax paid = $20,000 x 0.05 = $1,000

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Example of Proportional Tax

Formula for tax percentage paid:› Medicare tax is 1.45%› Annual income $30,000› Medicare tax = $30,000 x 0.0145 = $435› Annual income $500,000› Medicare tax=$500,000 x 0.0145 = $7,250

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Basic Income Calculations

Gross income - taxes = Disposable income› For most of us, disposable income is take-home pay.

Disposable income - Fixed expenses = Discretionary income› Fixed expenses are contractual obligations like rent, utilities,

insurance, and car payments.› Discretionary income is that we can spend or save.

– Does this include debt?? NO

Would the government want to find a way to increase disposable income? Why??

Would the government rather you spend or save your disposable income??

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Household Name

Gross Income ($)

Income, SS, & Medicare Taxes ($)

Federal Taxes Paid

as a % of Gross

IncomeDisposable Income ($)

Fixed Expenses ($)

Discretionary Income ($)

Jones 30,000 5,228 17.43% 24,773 19,673 5,100Roberts 50,000 9,758 19.52% 40,243 32,683 7,560Smith 70,000 16,502 23.57% 53,499 40,179 13,320Brown 90,000 23,432 26.04% 66,569 41,369 25,200Meeks 110,000 29,912 27.19% 80,088 41,208 38,880Adams 130,000 36,202 27.85% 93,798 46,998 46,800Charles 150,000 42,492 28.33% 107,508 49,620 57,888

Department of the Treasury, Internal Revenue Service, Publication 15 (Rev. January 2008).

What do we learn?1)We have a progressive tax system.2)Fixed expenses decrease as a percentage of income, as income increases.3)Discretionary income increases as wealth increases.

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Economic Concepts

Factors Affecting Interest Rates› The supply of money saved is primarily the total money that is

placed in demand deposit (checking) accounts, savings accounts, and money market mutual funds.

– law of supply relates to the price paid and the quantity of a resource that is provided at that price.

› The demand for borrowed funds is all of the money that is demanded in our economy at a given price.

– The law of demand states that as the price of an item de-creases, people will demand a larger quantity of that item,

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Table 1-4 Supply Table: Money Saved for Seven Sample Families

Annual Interest Rate (%) Jones Roberts Smith Brown Meeks Adams Charles Total

0 -$ -$ -$ -$ -$ -$ -$ -$ 2 - - - - - - - - 4 - - - 500 780 1,940 5,790 9,010 6 - - 670 1,250 1,940 2,720 7,530 14,110 8 100 200 930 1,760 2,020 3,890 12,000 20,900 10 200 500 1,500 3,000 3,500 7,000 16,000 31,700 12 250 750 2,500 5,000 6,000 10,000 20,000 44,500 14 300 1,000 3,250 9,000 12,000 15,000 25,000 65,550 16 400 1,200 4,500 12,000 18,000 23,000 31,000 90,100 18 500 1,500 6,000 15,000 25,000 28,000 38,000 114,000 20 500 1,700 8,000 18,000 30,000 32,000 40,000 130,200 22 500 1,700 8,000 18,000 30,000 33,000 41,000 132,200 24 500 1,700 8,000 18,000 30,000 33,000 41,200 132,400

Annual Savings ($000)

As interest rates increase, all people would desire to save more money, but at a decreasing rate.

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Economic Concepts

Factors Affecting Interest Rates› The supply of money saved is primarily the total money that is

placed in demand deposit (checking) accounts, savings accounts, and money market mutual funds.

– law of supply relates to the price paid and the quantity of a resource that is provided at that price.

› The demand for borrowed funds is all of the money that is demanded in our economy at a given price.

– The law of demand states that as the price of an item de-creases, people will demand a larger quantity of that item,

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Interest Rate (%)

Amount Financed ($)

Interest Paid ($)

0 180,000 01 155,454 24,5462 135,274 44,7263 118,595 61,4054 104,731 75,2695 93,141 86,8596 83,396 96,6047 75,154 104,8468 68,142 111,8589 62,141 117,85910 56,975 123,02511 52,503 127,49712 48,609 131,39113 45,200 134,80014 42,199 137,80115 39,543 140,45716 37,181 142,81917 35,071 144,92918 33,177 146,82319 31,468 148,53220 29,922 150,07821 28,516 151,48422 27,233 152,76723 26,059 153,94124 24,980 155,020

Table 1-5 Ann Smith's Demand for Money

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In a totally free market supply and demand will determine interest rates. We do not have a totally free market.

Federal Reserve Policy› The Federal Reserve is the central bank of the United States.

Monetary policy is the government’s action to alter the supply of money.

Goals of monetary policy› Economic growth› Price stability› Full employment

Factors Affecting Interest Rates (continued)

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Type of Rate Definition Rate (%)

Discount The charge on loans to depository institutions by the New York Federal Reserve Bank 2.50

Federal Funds The rate banks charge each other for overnight loans in minimum amounts of $1 million 2.23

T-bill, three months The rate on government treasury bills sold at a discount of face value in units of $10,000 1.33

Prime The interest rate that banks charge their most creditworthy customers 5.25

Source: Federal Reserve Statistical Release H.15 - April 7, 2008

Table 1-6 Money Rates, as of April 7, 2008

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Inflation is a primary concern for the FED. A primary goal is to assure that inflation remains in

check to create stability in prices. How do they attempt to control inflation?

› Open market operations› Discount rate› Reserve requirements


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Risk› Systematic Risk: Risk associated with economic, political, and

sociological changes that affect all participants on an equal basis.

– Frequently referred to as market risk

– This risk is not diversifiable› Unsystematic Risk: Risk unique to an individual, firm, or

industry.

– Frequently referred to as company specific risk

– This risk is diversifiable


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Chapter 2Financial Management and Planning

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What is management?

The process of working with or through others to achieve an individual or business goal by efficiently and effectively using resources.

Five basic functions› Planning› Organizing› Staffing› Directing› Controlling operations.

http://www.youtube.com/watch?feature=player_detailpage&v=b_slep81F4E

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Management Functions Planning is a systematic process that takes us from some

current state to some future desired state. › Strategic planning involves establishing an overall plan for the business.

– Where do we want our business to be at some time in the future?› Functional planning is driven by strategic plans and is related to

specific functional areas of a business such as accounting, marketing, or human resources.

– Financial planning– The reason so many businesses fail is because of a lack of adequate

financial planning.

Nobody begins a business with a plan for failure, but too many businesses have been started with a failure to plan.

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Management Functions (continued)

Goal setting is precursor to establishing a plan.› Goals must be measurable, achievable, and have a time frame.› Basic financial goals of a for-profit organization:

– To maximize the wealth of the business owners (investors) over the life of the business

– To meet interest payments on debt

– To grow

Goals vs Objectives› Goals are normally considered to be long term› Objectives are intermediate goals that measure progress toward the

overall long- term goal.

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Organizing is the second function of the manager and defines the structure of the business. › Who will do it? › What skills do they need? › What is the time frame that we have set in which to have it

accomplished? › Where will it be accomplished? › How do we get it accomplished?

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Staffing requires that the manager obtain the most capable personnel to implement the business plans. › Determine job requirements.› Develop a job description.

Directing (leading). Providing proper guidance and direction to others to accomplish the organization’s mission.


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Controlling is a three-step process:1) Establishing a standard of measurement

2) Measuring actual performance against the standard

3) Taking corrective action when actual performance varies from the established standard


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Forms of Business Ownership

United States Business Forms

Proprietorship71.91%

Public0.06%

C Corp7.35%S Corp

12.16%

Partnership8.52%

SOURCE: Internal Revenue Service, SOI Bulletin, Historical Table, Fall 2007. Excel ver. 4. August 2005. Securities & Exchange Commission filings.

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Forms of Business Ownership (continued)

A sole proprietorship is operated by an individual for profit.

A partnership is an association of two or more persons who carry out a business as co-owners for a profit.

A corporation is a legal entity with most of the rights of individuals

A limited liability corporation is a hybrid of a partnership and a corporation.

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A sole proprietorship is operated by an individual for profit.› Advantages

– No formal legal requirements– Title to property is in owner’s name– No formal organizational style– All that is needed to start is an idea and a desire

› Disadvantages– Capital structure limited– Unlimited liability– Life of business = life of business owner– May lack managerial skills– May be difficult to hire long-term employees or employees with

specific skill sets• Accountant

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A partnership is an association of two or more persons who carry out a business as co-owners for a profit.

– Advantages over sole proprietorship lies in the number of people involved.

› General partnership› Limited partnership

– Requires one general partner– “silent partners”

• Cannot participate in business

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Terms

Liability› Who pays?› Where does the money come from?

Taxes› Who pays?› What rate?

Buy-sell agreements› Stops the sale of interest to unknown people› Important because of liability issues

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The corporation is a legal entity according to U.S. law. › Incorporated in one of the fifty states or territories of the United States.

– Public Corporation: stock is sold to the public.– Private Corporation: Stock is not sold to the public.– All corporations are formed as C corporations unless they meet the

requirements of and request Subchapter S tax status.• Subchapter S corporation: Private corporation with special tax

status granted by Internal Revenue Service (IRS)• Maximum of 100 shareholders• No double taxation

Taxes› Who pays? What rate?

Forms of Business Ownership(continued)

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A Limited Liability Company (LLC) is a hybrid business entity having features of both partnerships and corporations.› Taxed as a partnership› Has limited liability for all owners› Flows through income and losses to individual owner’s tax returns › Not legal in all states


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Franchise not an actual form of ownership. A franchise is a business in which the buyer, who is the franchisee, purchases the right to sell the goods or services of the seller, who is the franchiser.

http://www.youtube.com/watch?feature=player_detailpage&v=uhSEVjTciA0

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What form to choose?› Liability› tax advantages› financial support› the owner’s desires› the type and location of the business.

Three types of business owners› http://www.youtube.com/watch?

feature=player_detailpage&v=uhSEVjTciA0

Where to form the business› http://www.youtube.com/watch?

feature=player_detailpage&v=gRV6xx4BftQ

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Starting a Business

Run a SWOT analysis› Strengths are the core competencies of a business. They are those factors

that will make your business succeed because you perform in these areas better than your competitor.

› Weaknesses are those areas of your company that definitely need improvement.

› Opportunities are factors that exist outside of your business, but that if taken advantage of, will help your business to grow and prosper (e.g., low interest rates for business loans).

› Threats are factors that exist in the environment that may impede the growth of your business, directly or indirectly (e.g., new competition).

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Development of a Business Plan

Executive summary: Part of business plan that investors review to determine if they want to read further. Two pages or fewer, the executive summary should contain:› Business strategy for success› Brief description of the market and what makes your business unique› Brief description of the product or service› Brief description of management teams’ qualifications› Summary of revenue and expense projections› Estimate of how much money is needed and how it will be used

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General Company Description:› Mission Statement:

– Company goals– Company objectives– Business philosophy

› Form or forms of business ownership› Products and services› Marketing plan

– 4 Ps: Price, Product, Promotion, Place.– Government contracts as source of revenue

› Operational plan› Management and organization› Personal financial statement of each owner or major stockholder› Startup expenses and capitalization› Financial plan; a 4-year projection of profit

Development of a Business Plan (continued)

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Development of a Business Plan (continued)

Appendices› Brochures, advertising materials, business cards› Industry studies› Maps and photos of location› List of equipment owned or purchased› Copies of leases or contracts› Letters of support from suppliers and future customers› Market research studies› List of assets available for a loan

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Business Succession Plans Determine who will take the business if owner is unable to

function. Succession Planning

› Buy-sell agreement is overt› Owner and spouse on same page› Heirs receive ownership rights directly, or in trust› Ownership by family members only or do we include non-family members?› Gather information from spouse and children when formulating a buy-sell

agreement or succession plan.› Consult with attorney and other professionals.

http://www.youtube.com/watch?feature=player_detailpage&v=vITv-jjve9Y

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Financing a Business or Raising Capital

Suppliers of funds include lenders and investors› Lenders increase debt and include banks and any other lender

– The amount of the loan.

– How the funds are used.

– What the loan will accomplish and how it makes the business stronger.

– How many years to repay the loan

– What collateral is being offered for the loan.

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Sources of Financing Sources of financing typically include

› Personal assets: savings, investments, credit cards and home equity lines.

› Equity financing: retained earnings, fixed assets (buildings, equipment and inventory) as collateral.

› Small Business Administration:– Not a lender but a guarantor of a percentage of the laon

amount.– 504-Major machinery or building construction or expansion.– 7(a)-Guarantee Loan Program.– Other programs: Micro-loan Technical Assistance Grants,

SBA Micro-loan and Patriot Express Pilot Loan Initiative.

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Investors and Grants

› Investors increase company equity and expect a positive return on their investment:

– Company owners

– Angel investors provide seed money and mentoring to start-up businesses

– Venture capitalist normally invests in companies with proven track record

› Grants are monies provided to the firm which do not have to be paid back as long as grantee provides services for which the grant was approved.

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Chapter 3

Financial Statements

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Statements

Personal Financial Statements Sole proprietors and partners Corporations

Audited statements› Why?› How?

– Independent auditors

– http://www.youtube.com/watch?feature=player_detailpage&v=g_9ySVOoiYk

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Financial Statement (Personal Form)

Single bank loan application form which incorporates two individual financial forms:

› Statement of financial position– Cash– Cash equivalents– Invested assets– Use assets – Liabilities– Net worth

› Personal cash flow statement– Income– Fixed expenses– Variable expenses

http://www.youtube.com/watch?feature=player_detailpage&v=T_8t2yTrCms

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NamesCash Inflow Adam Arin Debt Cash FlowSalary $45,000 $30,000 Mortgage (1st) $14,000Self Employment Mortgage (2nd)Dividends $150 Auto (1) $3,300Rents Auto (2)Alimony / Child Spt Credit Card 1Pensions etc. Credit Card 2Other Income $500 Furniture

Subtotals $45,650 $30,000Total Cash Inflow $75,650

TaxesAll Federal Income $13,000State IncomeLocal Income Total Debt Pmts $17,300Real Estate $1,659Other Taxes

Subtotals $14,659 $0 Savings Adam ArinTotal Tax Cash Flow $14,659 Company Retirement

Personal RetirementPersonal Savings

Insurance Emergency FundHome $750 Misc. Savings Auto $600 Subtotals $0 $0Health Total Savings Cash Flow $0LifeDisability Cash Flow AnalysisDental Total Cash Inflow $75,650 %Misc Ins. Total Tax Cash Flow $14,659 19.377%

Subtotals $1,350 $0 Total Ins. Cash Flow $1,350 1.785%Total Ins. Cash Flow $1,350 Total Debt Pmts $17,300 22.868%

Total Savings Cash Flow $0 0.000%Living Expenses $42,341 55.970%

Cash Mgt and Budgeting

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Assets Liabilities

Liquid Assets Totals % of Total Assets Consumer Debt Totals % of Total AssetsCash and Checking $3,300 Current Bills $400Savings Accounts $1,200 Credit Cards $2,000Money Market Funds $1,200 $5,700 3.002% Installment Loans $8,000

Other Debts $3,000 $13,400 7.056%Investment Assets

Long Term DebtShort-Term Assets Mortgage $100,000CD's Mortgage (2nd)Treasury Bills Life Insurance LoansOther ST Investments $0 0.000% Student Loans

Retirement Account Loans $100,000 52.659%Long Term InvestmentsStocks $2,000 Total Debt $113,400 59.716%BondsMutual Funds Net Worth $76,500 40.284%IRA Retirement Accounts $2,000Corporate Retirement Accts $4,000 2.106% Total Liabilities and NW $189,900

Other InvestmentsBusiness OwnershipInvestment PartnershipsReal Estate Investments $0 0.000%

Personal AssetsResidence $150,000Automobiles $23,000Personal PropertyOther Personal Property $7,200 $180,200 94.892%

Total Assets $189,900 100.000%

Lawrence Byerly PhD © 2011

Personal net worth

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Personal Income Statement (Cash Flow Statement)

Income—Include all sources› Wages, tips, overtime› Interest on savings, stock dividends, etc.

Fixed expenses› Contractual, must be paid› Rent, insurance, utilities, car payments, etc.

Variable expenses› You control level of expenses (food, clothing)

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3 Avg % of Total Expenses 3 Avg % of Total ExpensesHousing GivingRent $0 0.000% Charitable $0 0.000%Telephone $0 0.000% Non-Charitable $0 0.000%Utilities $3,200 $3,200 4.230% Total Giving Expenses $0 $0 0.000%Maintenance $0 0.000%Furnishings $0 0.000% LeisureImprovements $0 0.000% Vacations $0 0.000%Other $0 0.000% Hobbies $0 0.000%Total Housing Expenses $3,200 $3,200 4.230% Entertainment (not cable) $2,000 $2,000 2.644%

Cable $0 0.000%Family Restaurants $0 0.000%Groceries $2,200 $2,200 2.908% Other $0 0.000%Clothing $2,000 $2,000 2.644% Total Leisure Expenses $2,000 $2,000 2.644%Medical $1,500 $1,500 1.983%Dry Cleaning $0 0.000% Summary ExpensesChild Care $0 0.000% Total Tax Cash Flow $14,659 19.377%Education $0 0.000% Total Ins. Cash Flow $1,350 1.785%Legal $0 0.000% Total Debt Pmts $17,300 22.868%Alimony/ Chold Spt $0 0.000% Total Savings Cash Flow $0 0.000%Misc Family Expenses $0 0.000% Living Expenses (here) $0 0.000%

Total Family Expenses $5,700 $5,700 7.535% Total Cash Outflows $33,309 44.030%

Transportation Discretionary IncomeGas and Oil $2,100 $2,100 2.776% Total Cash Inflow $75,650Maintenance $0 0.000% Total Cash Outflow $33,309Other $0 0.000% Discretionary Income $42,341 55.970%Total Transportation Exp. $2,100 $2,100 2.776%

Monthly Expenditures (or Add Most Recent in Column 3

entrepreneurial finance fifth edition

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