Practical Financial Management, 3rd Editionby William R. LasherNichols College 2003 South-Western/Thomson LearningPowerPoint Presentation Slides by

FoundationsChapter 1 2003 South-Western/Thomson Learning

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Main Areas of FinanceInvestments and financial marketsFinancial management of corporationsFields are separate but related

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Financial AssetsReal assetan object that provides a service, such as a house, car, art, coinFinancial asseta document representing a claim to incomeStockownership interest in a companyEntitled to a share of the firms profits, either dividends or future growthBonddebt interest in a companyEntitled to interest and repayment of principalInvesting involves buying financial assets in the hope of earning a returnCan be made directly or indirectly (buying shares in a mutual fund)

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Financial MarketsFinancial MarketFinancial assets are issued by corporations and bought by investors in financial marketsA framework or organization in which people can buy/sell securities Stock market (NYSE, AMEX, OTC)--entire network of brokers and exchanges all connected togetherStockbroker (broker)--person who is licensed to trade securities for a commission

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Financial MarketsSecondary marketplace where investors trade securities among themselves (NYSE, etc.)Most transactions are of this typePrimary marketmarket where securities are initially sold (I.P.O.)InvestmentsMaking decisions about buying and selling stock and bondsFinancial managementDecisions about raising money and how to spend it

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Figure 1.1: Simplified Financial System

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Raising MoneyFinancing means raising money to acquire somethingForms of FinancingIssuing stock (equity financing)Borrowing money (debt financing)BankIssuing bondsLeasingInternal financing (retaining earnings)Still considered equity financing

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Raising MoneyField of finance includes raising money and investing moneyChanging Focus of FinanceFinance used to be narrowly limited to financial market activityHowever has expanded to includePortfolio formation and analysisA portfolio is a collection of securitiesFinancial management within an organization

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Financial ManagementFinancial Management is the management and control of money and money-related operations within a businessExecutive in charge of finance departmentCFO: Chief Financial Officer (AKA: VP of Finance) Typically reports directly to the President of the corporation

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Financial ManagementRefers to the functions of the finance departmentKeeping recordsReceiving payments from customersMaking payments to suppliersBorrowing fundsPurchasing assetsSelling stockPaying dividends, etc.Accounting department is included in the broad definition of finance.

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Financial ManagementBusiness DecisionsFinance department is in charge of:Determining which assets a firm should purchaseAcquiring another firmExpanding operations A different product lineCurrent operations expanding to another countryDeciding how those assets will be financedEquityDebtLoan via bankBond issue

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Financial ManagementOversightFinance department must also perform an oversight functionLooking over everyones shoulder to make certain money is being used effectivelyFor example,Are manufacturing costs too high?Are advertising costs too high?

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The Price of SecuritiesA Link Between the Firm and the MarketInvestors buy securities for the future cash flows expected from themPrice investors are willing to pay depends on expectations of how well the companies are likely to doLink between company management and investors comes from this relationship between price and expected financial resultsEverything firm does is evaluated by market and graded by either an , , or no change in security price

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The Price of SecuritiesA Link Between the Firm and the MarketDoes management care what grade it receives?YES! Why?Management will need to issue new securities in the future (to raise $) and therefore want a high security priceStockholders own the firm and if the stock price declines shareholders will be disgruntled

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Finance and AccountingAccounting: a system of record-keeping designed to portray a firms operations in a fair/unbiased manner Generate financial statements which are provided to the marketplaceFinance: a process of decision-making related to raising money, analyzing results, etc.Use the output generated by accountants as inputs in finance

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Finance and AccountingFinance department generally consists of both the accounting department and the treasury departmentController is in charge of the accounting departmentTreasury department deals with finance activitiesCrossover is possibleUsually easier for an accountant to move to the treasury department

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Figure 1.2: Finance Department Organization

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The Importance of Cash FlowAccounting attempts to reflect a firms financial results in a way that represents what is physically occurringFinance is interested in how cash is flowing (or expected to flow)We need a cash amount because well be looking at returns on money invested, and you cant invest a non-cash numberCash is King

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The Importance of Cash FlowA: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 deductionnot the depreciation itself.

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The Language of FinanceAccounting is the language of financeThus all finance professionals need some accounting knowledgeLevel of accounting knowledge needed depends on jobFinancial analyst needs to know LOTS of accounting because s/he investigates companies and makes recommendations concerning their value in market (must decipher complex financial statements as part of that process)Stockbrokers do not need as thorough an understanding because they generally trade securities based on the financial analysts recommendation

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Financial TheoryThe Relationship with EconomicsFinancial theory developed from economicsModern financial theory began as a branch of economics in the 1950sToday finance is viewed as a separate fieldScholars in both fields make observations between business world and government and attempt to model the behavior

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Figure 1.3: The Influence of Accounting, Economics and Financial Theory on Financial Management

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Forms of Business Organization and Their Financial ImpactBusinesses can be legally or organized asA sole proprietorshipA partnershipA corporationLegal organization has an impact onRaising moneyTaxationFinancial liabilityIssues really only important regarding small businessesVirtually all large corporations are organized as C-type organizations

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The Proprietorship FormGetting startedEasy to doTaxesProfit is taxed as personal income to the business ownerAre taxed only onceTaxed at personal income tax ratesRaising moneyIf entrepreneur decides to go outside the firm to raise money, s/he can obtain a loanLending money is riskyBest possible outcome: repayment of principal and interestWorst possible outcome: lose everythingThus, most lenders require collateralMany entrepreneurs use their house as collateral

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The Corporate FormGetting startedRequires a legal incorporation processTakes time, work and moneyTaxesWhen business makes a profit taxes are paid twiceThe corporation pays a tax at the corporate tax rateDividends paid to individuals are taxed at an individuals personal tax rate

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The Corporate FormExample A:Under the corporate form the $100,000 is first subject to a 34% corporate tax of $34,000, leaving earnings of $66,000. If Hazel were to take these earnings she would have to declare them as a dividend and pay personal taxes at 28%, or $18,480. In a sole proprietorship the $100,000 is taxed only once at the personal rate of 28%, for a total tax bill of $28,000. The difference in taxes of $24,480 is significant.

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The Corporate FormRaising MoneyMoney for a corporation can be raised byBorrowingA corporation faces the same issues as a sole proprietorship when raising moneyOffering stock to investorsIf less than a 50% interest is sold, original owner still maintains effective controlOwning stock is riskyBest possible outcome: may get richWorst possible outcome: may lose all of your investment

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The Truth About Limited LiabilityLimited liability states that a stockholder is not liable for a corporations debtsImplies that the most stockholder can lose is 100% of his investment in the stockIn a sole proprietorship, the business owner stands to lose his personal property if all the assets of the business are insufficient to cover all liabilitiesPersonal guarantees make entrepreneurs liable for loans made to their businessDestroys the value of limited liability

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S-Type CorporationsMajor financial advantage of corporate formAbility to raise money by issuing stockMajor financial disadvantageDouble taxation of earningsGovernment encourages formation of small businesses because they create numerous jobsGovernment allows creation of S-type corporationLets small businesses avoid double taxationOffers limited liabilityOffers ability to sell stock to raise money

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Goals of ManagementEconomicsgoal is to maximize profitBut what about R&D? If you eliminate R&D youll increase short-term profit and hurt long-term profitFinanceStockholders own the company so the goal is to maximize their wealth, generally by maximizing the stock priceThis goal bypasses the concern of whether the short-term or long-term is more important, because stock price incorporates both! If R&D were eliminated the stock price would not rise, but rather, drop

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Stakeholders and Conflicts of InterestConstituencies of the company who have a vested interest in the way the firm is operated and includeStockholdersEmployeesCustomersCommunityManagementCreditorsSuppliers

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Conflicts of InterestAn IllustrationExample: Employees want management to build an athletic facility on corporate groundsBenefitmore effective employees (feel better, happier, therefore more productive)Costwill come from profits that belong to stockholdersThis represents a conflict of interest between stockholders and employeesSomething that benefits one group and takes away from another

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ManagementA Privileged Stakeholder GroupManagement represents a privileged stakeholder groupThe ownership of a widely held company is very dispersed so no one has enough control to influence managementIBM has almost 2 billion shares outstanding, and over 600,000 shareholdersso no one person has enough control to influence management This allows top management to become entrenched in positions controlling large amounts of resourcesManagement is able to use these resources for their own benefit

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The Agency ProblemManagement (agent) is controlling resources owned by stockholders (principal) and may not make the decisions stockholders wantThe Abuse of AgencyPrivileges and luxuries provided to executives are called perquisites or perksExamplemanagement compensation Management receives exorbitant salaries/bonuses ($50+ million) while the company performance is poorAdditional perks include boats, airplanes, country club memberships, etc.

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The Agency ProblemsControlling the agency problemEfforts to manage agency problem includeMonitor management (audits)Tie management bonuses to corporate stock performance via a stock option or to corporate profit

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Creditors Versus StockholdersA Financially Important Conflict of InterestA creditor is anyone owed money by a business including lenders, vendors, employees, or the governmentActions taken by the leveraged company that are riskier than before they borrowed money place creditors at riskLenders generally put clauses in loan agreements to prevent this from occurring

FMDS 341--Principles of FinanceChapter 1: Foundations, Practical Financial Management, by W. LasherFMDS 341--Principles of FinanceChapter 1: Foundations, Practical Financial Management, by W. Lasher