Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Foundations of Finance
Arthur J. Keown
J. William Petty
John D. Martin
David F. Scott, Jr.
Chapter 1
An Introduction to the Foundations
of Financial Management – The Ties
that Bind
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Chapter Objectives
• Identify the goal of the
firm.
• Compare the various
legal forms of business
organization and
explain why the
corporate form of
business is the most
logical choice for a firm
that is large or
growing.
• Describe the corporate
tax features that affect
business decisions.
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• Describe the corporate
tax features that affect
decisions.
• Explain the 10
principles that form the
foundations of financial
management.
• Explain what has led to
the era of the
multinational
corporation.
Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
The Goal of the Firm
• The goal of the firm is maximization
of shareholder wealth
or
• Maximization of the price of the
existing common stock
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Profit Maximization
• Stresses the efficient use of capital
resources
• Not specific to time frame for profits
to be measured
• Goals are not precise, allow for
misinterpretation
• Ignores uncertainty and timing
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Benefits of Maximizing
Shareholder Wealth
• Good decisions are those that create
wealth for the shareholder
• Societal benefits as businesses
compete to create wealth
• Includes effects of all financial
decisions
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Legal Forms of Business
Organization
• Sole Proprietorship
• Partnership
• Corporation
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Sole Proprietorship
• Business owned by an individual
• Owner maintains title to assets
and profits
• Unlimited liability
• Termination occurs on owner’s
death or by owner’s choice
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Partnerships
• Two or more owners
• General Partnership
– Each partner is fully responsible
for liabilities
• Limited Partnerships
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Partnerships
• Limited Partnership and Limited
Liability Company
– Allows one or more partners limited
liability based on amount of capital
invested
– Must have one general partner with
unlimited liability
– Names of limited partners may not
appear in name of firm
– Limited partners may not participate in
management decisions.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Corporation
• Legally functions separate and apart from its
owners
– Can sue, be sued, purchase, sell, and own
property
• Owners who dictate direction and policies
– Elect a board of directors
• Investors liability is restricted to amount of
investment in company
• Life continues with transfer of ownership
• Taxed separately
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Comparison of Organizational
Forms
• Large growing firms choose the
corporate form
– Ease in raising capital
– Limited liability
– Transfer of ownership is simple
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Comparison of Organizational
Forms
• Sole Proprietorship and General
Partnership
– Unlimited liabilities
– Not as easy to raise capital
• Limited Partnership
– Limited liability for partners
– Practical number of partners restricted
– Restricted marketability of interest in
partnership
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Organizational Form and Taxes
• Corporation
– Double taxation of dividends
– Tax act of 2003 limited tax rate on
dividends to stimulate the
economy
• Ends in 2008 unless Congress takes
action
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Organizational Form and Taxes
• S-Type Corporations
– Benefits
• Limited liability
• Taxed as partnership
– Limitations
• Owners must be people
• Can’t be used for joint ventures
between two corporations
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Organizational Form and Taxes
• Limited Liability Corporations
– Benefits
• Limited liability
• Taxed like a partnership
– Limitations
• Qualifications vary from state to state
• Can’t appear like corporation
otherwise will be taxed like one
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
The Role of the Financial
Manager in a Corporation
HOW THE FINANCE AREA FITS INTO A CORPORATION
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Objectives of Income Taxation
• Raise revenues for government
expenditures
• Achieve socially desirable goals
• Economic stabilization
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Types of Taxpayers
• Individuals
– employees, self-employed persons, members of
partnerships
– Report income on personal tax return
• Corporations
– separate legal entity
– Report income on corporate tax return
– Distributed dividends taxed to shareholders
• Fiduciaries
– estates and trusts
– Pay taxes on undistributed income
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Computing Taxable Income
• Taxable Income
– Gross income less tax deductible expenses, plus
interest income and dividend income
• Gross Income
– Dollar sales from a product or service less cost
of production or acquisition
• Tax Deductible Expenses
– Operating expenses (marketing, depreciation,
administrative expenses) and interest expense
• Dividends paid are not deductible
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Computing Taxable Income ($000’s)
Sales
Cost of Goods Sold
Gross Profit
Operating Expenses
Administrative Expenses
Depreciation Expense
Marketing Expenses
Total Operating Expenses
Operating Income
Other Income
Interest Expense
Taxable Income
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Foundations of Finance
$50,000
23,000
$27,000
$4,000
1,500
4,500
$10,000
$17,000
0
1,000
$16,000
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Corporate Tax Rates
Income
$ 0 - $50,000
$50,001 - $75,000
$75,001 - $10,000,000
Over $10,000,000
Rate
15%
25%
34%
35%
Additional surtax:
• 5% on income between
$100,000 and $335,000
• 3% on income between
$15,000,000 and $18,333,333
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Marginal Tax Rates
• Rates applicable to next dollar of
income
• Used in financial decision-making
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Other Corporate Tax
Considerations
• Dividend Exclusion
– A corporation may typically exclude 70% of any
dividend received from another corporation.
• Depreciation Expense
– A corporation may expense an asset’s cost over
its useful life
• Capital Gains and Losses
– Capital Gains taxed as ordinary income. Capital
losses cannot be deducted from ordinary income.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Ten Principles That Form The
Foundations of Financial
Management
“…although it is not necessary to
understand finance in order to understand
these principles, it is necessary to
understand these principles in order to
understand finance.”
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Principle 1: The Risk-Return
Trade-off
• We won’t take on additional risk
unless we expect to be compensated
with additional return.
• Investment alternatives have
different amounts of risk and
expected returns.
• The more risk an investment has, the
higher its expected return will be.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Principle 2: The Time Value
of Money
• A dollar received today is worth
more than a dollar received in the
future.
• Because we can earn interest on
money received today, it is better to
receive money earlier rather than
later.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Principle 3: Cash—Not
Profits—Is King
• Cash Flow, not accounting
profit, is used as our
measurement tool.
• Cash flows, not profits, are
actually received by the firm
and can be reinvested.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Principle 4: Incremental Cash
Flows
• It is only what changes that counts
• The incremental cash flow is the
difference between the projected
cash flows if the project is selected,
versus what they will be, if the
project is not selected.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Principle 5: The Curse of
Competitive Markets
• It is hard to find exceptionally profitable
projects
• If an industry is generating large profits,
new entrants are usually attracted. The
additional competition and added capacity
can result in profits being driven down to
the required rate of return.
– Product Differentiation, Service and
Quality can insulate products from
competition
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Principle 6: Efficient Capital
Markets
• The markets are quick and the
prices are right.
• The values of all assets and
securities at any instant in time
fully reflect all available
information.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Principle 7: The Agency
Problem
• Managers won’t work for the owners
unless it is in their best interest
• The separation of management and
the ownership of the firm creates an
agency problem.
– Managers may make decisions that are
not in line with the goal of maximization
of shareholder wealth.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Principle 8: Taxes Bias
Business Decisions
• The cash flows we consider
are the after-tax incremental
cash flows to the firm as a
whole.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Principle 9: All Risk is Not
Equal
• Some risk can be diversified
away, and some cannot
• The process of diversification
can reduce risk, and as a result,
measuring a project’s or an
asset’s risk is very difficult.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Principle 10: Ethical Behavior Is Doing
the Right Thing, and Ethical Dilemmas
Are Everywhere in Finance
• Each person has his or her own
set of values, which forms the
basis for personal judgments
about what is the right thing
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Finance and the Multinational
Firm
• U.S. corporations are looking to
international expansion
– Collapse of communism
– Acceptance of free market system
developing in the Third World
countries
– PC’s and the internet
– Freer access to international
markets
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Foundations of Finance
Arthur J. Keown
J. William Petty
John D. Martin
David F. Scott, Jr.
Chapter 2
The Financial Markets and Interest
Rates
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Chapter Objectives
• Understanding the historical relationship
between internally generated and
externally generated sources of funds.
• Understand the financing mix that tends to
be used by the firms raising long-term
capital.
• Explain why the financial markets exist in a
developed country.
• Explain the financing process by which
savings are supplied and raised by major
sectors in the economy.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Chapter Objectives
• Describe key components of the U.S.
financial market system.
• Understand the role of the investmentbanking business in the context of raising
corporate capital.
• Distinguish between privately placed
securities and publicly offered securities.
• Be acquainted with securities floatation
costs and securities markets regulations.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Chapter Objectives
• Understand the rate-of-return relationships
among various classes of financing
vehicles that persist in the financial
markets.
• Be acquainted with recent interest rate
levels and the fundamentals of interest rate
determination.
• Explain the popular theories of the term
structure of interest rates.
• Understand the relationships among the
multinational firm, efficient financial
markets, and the inter-country risk.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Principles Used in this Chapter
Principle 1: The Risk-Return Tradeoff - We
Won’t Take on Additional Risk Unless We
Expect to Be Compensated with Additional
Return.
Principle 6: Efficient Capital Markets - The
Markets are Quick and the Prices Are
Right.
Principle 10: Ethical Behavior Is Doing the
Right Thing, and Ethical Dilemmas Are
Everywhere in Finance.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Federal Funds Rate
• Short-term market rate of interest
• Serves as a sensitivity indicator of
the direction of future changes in
interest rates
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Objectives of the Fed
• Maximum sustainable
employment
• Price stability
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Recent Interest Rate Cycles
Early 1994 & Inflation
1997
Raise interest
Rates
Fall 1998
International Pressures
Lower
interest rates
Summer
1999
Tight labor markets, aggregate real growth,
inflation
Raise interest
rates
Early 2001
Contracting manufacturing output, slower
business capital spending, equity market
sell-off, recession
Lower
interest rates
Summer
2004
Firming Labor market, stronger retail sales,
improving industrial production, hot housing
market, increases in energy prices, all
suggesting unacceptable future rates of
inflation.
Raise interest
rates
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Nonfinancial Corporate Business
Sources of Funds, 1981-2000
• Changes in market
conditions
influence the way
corporate funds
are raised
• Example: High
interest costs
discourage the use
of debt.
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External
Funds
27.70%
Foundations of Finance
Internal
Funds
72.30%
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Corporate Securities Offered for
Cash
• Nonfinancial
Corporations- 3yr.
Cash Weighted
Average, 20012003
Equities
14.30%
• Total Volume($M)
– $1,288,515
Source:Statistical Supplement to the
Federal Reserve Bulletin, Table 1.46,
October 2004, A29.
Foundations of Finance
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Bonds
and
Notes
85.70%
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Debt/Equity Mix
• U.S. tax system favors debt as
means of raising capital
• Interest expense is deductible
• Dividends paid are not
deductible
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Financial Markets
• Financial markets are institutions
and procedures that facilitate
transactions in all types of financial
claims
• Financial markets exist in order to
allocate the supply of savings in the
economy to the demanders of those
savings.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Financial Markets
• Real assets are tangible assets
such as houses, equipment, and
inventories.
• Financial assets represent
claims for future payments in
other economic units.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Financial Markets
• Underwriting — the purchase of financial
claims of borrowing units and reselling
them at a higher price to other investors.
• Secondary Markets — trading in already
existing financial claims
• Financial Intermediaries — major financial
institutions i.e. commercial banks, savings
and loans, credit unions, life insurance
companies, mutual funds etc.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Financial Markets
• Indirect Securities – financial claims
offered by financial intermediaries to
economic units with excess savings
• Direct Securities – financial claims
purchased by financial
intermediaries with proceeds from
the sale of indirect securities
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
The Financing Process
Sector
Funds
Raised
($)
Funds
Supplied
($)
Net Funds
Supplied ($)
Households
447.4
397.1
(50.3)
Nonfinancial
Corporate
Business
447.5
383.8
(63.7)
U.S. Gov’t
73.9
62.9
(11.0)
State and Local
Gov’ts
56.4
48.4
( 8.0)
320.2
561.7
Foreign
241.5
Source: Flow of Funds Accounts, First Quarter 2000, Flow if Funds Section, Statistical Release Z.1
(Washington, D.C.; Board of Governors of the Federal Reserve System, June 9,2000).
Foundations of Finance
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Movement of Savings
• Direct Transfer of Funds
• Indirect Transfer of Funds Using
an Investment Banker
• Indirect Transfer of Funds Using
the Financial Intermediary
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Three Ways to Transfer Financial
Capital in the Economy
Three Ways to Transfer Financial Capital in the Economy
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Public Offerings and Private
Placements
• Public Offering – both individuals and
institutional investors have the
opportunity to purchase securities
• Private Placement (direct
placement) – the securities are
offered and sold to a limited number
of investors
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Primary and Secondary Markets
• Primary Markets – Securities are offered
for the first time to investors – a new issue
of stock. Increases the total stock of
financial assets outstanding in the
economy.
• Secondary Markets – Transactions in
currently outstanding securities. All
transactions after the initial purchase.
Sales do not affect the total stock of
financial assets that exist in the economy.
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Money Market and Capital Market
• Money Market: all institutions and
procedures that provide for
transactions in short-term debt
instruments
• Capital Market: all institutions and
procedures that provide for
transactions in long-term financial
instruments
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Organized Security Exchanges and
Over-the-Counter Markets
• Organized Security Exchanges—Tangible
entities; physically operate space, where
financial instruments are traded on the
premises
– National and regional exchanges
• New York Stock Exchange
• American Stock Exchange
• Chicago Stock Exchange
• Over-The-Counter Markets—All security
markets except the organized exchanges
– Money Market
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Stock Exchange Benefits
• Provides a continuous market
• Establishes and publicizes fair
security prices
• Helps businesses raise new capital
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Listing Requirements
• Listing criteria varies from
exchange to exchange. General
requirements include:
*Profitability
*Market Value
*Public Ownership
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Investment Banker
• A financial specialist involved as an
intermediary in the merchandising of
securities; facilitates flow of savings
from economic units that want to
invest in those units that want to
raise funds.
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Functions of an Investment
Banker
• Underwriting
• Distributing
• Advising
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Distribution Methods
•
•
•
•
•
Negotiated Purchase
Competitive Bid Purchase
Commission or Best Efforts Basis
Privileged Subscription
Direct Sales
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Private Placements
• Advantages
– Speed
– Reduced Flotation Costs
– Financing Flexibility
• Disadvantages
– Interest Costs
– Restrictive Covenants
– Possible Future SEC Registration
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Market Regulation
• Securities Act of 1933 — Aims to provide
potential investors with accurate, truthful
disclosure about the firm and new securities
being offered.
• Securities Exchange Act of 1934 — Created
SEC to enforce federal securities laws
• Securities Acts Amendments of 1975 —
Created a national market system
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Securities Exchange Act of
1934
• Major security exchanges must
register with the SEC
–
–
–
–
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Insider trading is regulated
Prohibits manipulative trading
SEC control over proxy procedures
Gives Board of Governors of Federal
Reserve System responsibility for setting
margin requirements
Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Sarbanes-Oxley Act of 2002
• Congress passed in July 2002 the
Public Accounting and Reform and
Investor Protection Act
• The Act contains 11 titles which
tighten significantly the latitude
given corporate advisors who have
access to or influence company
decisions.
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Sarbanes-Oxley Act of 2002
Key Elements
•
•
•
•
•
•
•
•
•
•
•
Public Company Accounting Oversight Board
Auditor Independence
Corporate Responsibility
Enhanced Financial Decisions
Analysts Conflicts of Interest
Commission Resources and Authority
Studies and Reports
Corporate and Criminal Fraud Accountability
White-Collar Crime Penalty Enhancements
Corporate Tax Returns
Corporate Fraud and Accountability
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Rates of Return in Financial
Markets
• Opportunity Cost — Rate of return on next
best investment alternative to the investor
• Standard Deviation — Dispersion or
variability around the mean, or average of
the rate of return in the financial markets
• Maturity Premium — Additional return
required by investors in long-term
securities to compensate them for greater
risk of price fluctuations on those
securities caused by interest rate changes
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Rates of Return in Financial
Markets
• Liquidity Premium — Additional return
required by investors in securities that cannot
be quickly converted into cash at a
reasonably predictable price.
• Real Return — Return earned above the rate
of increase in the general price level for
goods and services in the economy (the
inflation rate)
• Real Rate of Interest — Rate of increase in
actual purchasing power—after adjusting for
inflation
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Term Structure of Interest
Rates
• The relationship between a debt
security’s rate of return and the
length of time until the debt
matures.
• Also called “Yield to Maturity”
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Term Structure of Interest
Rates
Explained by:
• Unbiased Expectations Theory
• Liquidity Preference Theory
• Market Segmentation Theory
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Unbiased Expectations
Theory
• Term Structure is determined
by an Investor’s expectations
about future interest rates.
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Liquidity Preference Theory
• Investors require maturity
premiums to compensate them
for buying securities that
expose them to the risks of
fluctuating interest rates
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Market Segmentation Theory
• Legal restrictions and
personal preferences limit
choices for investors to
certain ranges of maturities
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Financial Markets and
Intercountry Risk
• Financial System Risk
• Political System Risk
• Exchange Rate Risk
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Foundations of Finance
Arthur J. Keown
J. William Petty
John D. Martin
David F. Scott, Jr.
Chapter 3
Understanding Financial Statements
and Cash Flows
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Chapter Objectives
• Compute a company’s profits as
reflected by an income statement.
• Determine a firm’s accounting book
value, as presented in a balance
sheet.
• Measure a company’s free cash
flows.
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Principles Used in this Chapter
Principle 3: Cash-Not Profits-Is King
Principle 7: Managers Won’t Work for
the Owners Unless It’s in Their Best
Interest
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Basic Financial Statements
• Income Statement
• Balance Sheet
• Statement of Cash Flows
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Income Statement
• Profit/Loss Statement
• Indicates the amount of profits
generated by a firm over a given
period of time
• Sales – Expenses = Profit
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Income Statement
Terminology
• Revenue (Sales)
– Money derived from selling the company’s product or
service
• Cost of Goods Sold (COGS)
– The cost of producing or acquiring the goods or
services to be sold
• Operating Expenses
– Expenses related to marketing and distributing the
product or service and administering the business
• Financing Costs
– The interest paid to creditors and the dividends paid to
preferred stockholders
• Tax Expenses
– Amount of taxes owed, based upon taxable income
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Income Statement
Sales
Less cost of goods sold
= Gross profit
Less operating expenses
= Operating income
Less interest expense
= Earnings before taxes
Less corporate taxes
= Earnings before preferred dividends
Less preferred stock dividends
= Net income available to common
stockholders
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Starbucks Corporation
Income Statement 2003 ($M)
Sales
Cost of Goods Sold
Gross Profit
Operating Expenses
Marketing expenses and general and
Administrative expenses
$227
Depreciation Expense
206
Total Operating Expenses
Operating Profits
Interest Expense
Earnings before taxes
Income taxes
Net income
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Foundations of Finance
$4,076
3,207
$ 869
$ 433
$ 436
3
$ 433
165
$ 268
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Balance Sheet
• Provides a firm’s financial position at a
specific point in time
• Assets are resources owned by the firm
• Liabilities and owner’s equity indicate how
those resources are financed
Total Assets =
Liabilities (debt) + Shareholder’s Equity
Or…A= L+OE
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Balance Sheet Terminology
• Current assets or gross working capital
comprise assets that are relatively liquid,
or expected to be converted into cash
within 12 months.
• Current assets typically include:
– Cash
– Accounts Receivable
payments due from customers who buy on credit
– Inventory
raw materials, work in process, and finished goods
held for eventual sale
– Other expenses
Prepaid expenses are those items paid for in
advance
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Balance Sheet Terminology
• Fixed Assets – Assets held for more than
one year. Typically Include:
– Machinery and equipment
– Buildings
– Land
• Other Assets – Assets that are not current
assets or fixed assets
– Patents
– Copyrights
– Goodwill
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Balance Sheet Terminology
• Debt (Liabilities)
– Money that has been borrowed and must
be repaid at some predetermined date
– Debt Capital
• financing provided by a creditor
• Current or short-term debt and long-term debt
• Current or short-term must be repaid within
the next 12 months
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Balance Sheet Terminology
• Current Liabilities:
– Accounts payable
• Credit extended by suppliers to a firm when it
purchases inventories
– Accrued expenses
• Short term liabilities incurred in the firm’s
operations but not yet paid for
– Short-term notes
• Borrowings from a bank or lending institution due
and payable within 12 months
• Long-Term Debt
– Loans from banks or other institutions for longer than
12 months
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Balance Sheet Terminology
• Equity
• Includes the shareholder’s investment
– Preferred stock
– Common stock
• Treasury Stock
– stock that was once outstanding and has been
re-purchased by the company
• Retained Earnings
– cumulative total of all the net income over the
life of the firm, less common stock dividends
that have been paid out over the years
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Balance Sheet
• ASSETS
– Current Assets
– Fixed Assets
• Total Assets
• LIABILITIES
– Current Liabilities
– Long-Term Liabilities
• Total Liabilities
• OWNER’S EQUITY
– Preferred Stock
– Common Stock
– Retained earnings
• Total Owner’s Equity
• Total liabilities + OE
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Terms
• Net Working Capital
Current assets – current liabilities
• Debt Ratio
Percentage of debt a firm uses to finance its
assets
• Accrual Basis Accounting
Recording revenues when earned and expenses
when incurred, rather than when cash is
exchanged
• Free Cash Flows
Cash flow that is free and available to be
distributed to the firm’s investors.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Free Cash Flows
Free cash flows:
(After-tax cashflows from operations)
Less
(Increase or decrease in net working
capital)
Less
(Increase or decrease in gross fixed
assets)
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Traditional Statement of Cash
Flows
• Three sections:
– Cash flows from Operating
Activities
– Cash flows from Investing
Activities
– Cash flows from Financing
Activities
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
After-Tax Cash Flows From
Operations
Operating Income (EBIT)
+ Depreciation
- Income tax expense
= After-tax cash flows from
operations
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Change in Operating Working
Capital
Change in operating working capital =
(change in current assets) (change in current liabilities)
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Compute the Change in Fixed
Assets
• The final step involves
computing the change in Gross
Fixed Assets (not net Fixed
Assets)
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Starbucks Free Cash Flows
($M)
After-tax cash flows from operations
$477
Less 2003 investments in:
Investments in net working capital $ 4
Investments in Long Term Assets
Total investments
$ 570
Free cash flows
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566
$ (93)
Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Financing Cash Flows
A firm can either receive money from or
distribute money to its investors. The
firm can:
1. Pay interest to lenders
2. Pay dividends to stockholders
3. Increase or decrease in long-term debt
4. Issue stock to new shareholders or
repurchase stock from current
shareholders
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Foundations of Finance
Arthur J. Keown
J. William Petty
John D. Martin
David F. Scott, Jr.
Chapter 4
Evaluating a Firm’s Financial
Performance
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Learning Objectives
After reading this chapter, you should
be able to:
 Explain the purpose and importance
of financial analysis.
 Calculate and use a comprehensive
set of measurements to evaluate
a company’s performance.
 Describe the limitations of financial
ratio analysis.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Principles Used in this
Chapter
• Principle 7: Managers Won’t Work the
Owners Unless it is their best
Interest.
• Principle 5: The Curse of Competitive
Markets – Why It’s Hard to Find
Exceptionally Profitable Markets.
• Principle 1: The Risk Return TradeOff – We Won’t Take on Additional
Risk Unless We Expect to Be
Compensated with Additional Return.
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Financial Ratios
• Ratios give us two ways of
making meaningful comparisons
of a firm’s financial data:
– Trends across time
– Comparisons with other firms’
ratios
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Uses of Financial Ratios
within the Firm
• Identify deficiencies in a firm’s
performance and take corrective
actions.
• Evaluate employees’ performance
and determine incentive
compensation.
• Compare the financial performance
of different divisions within the firm
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Uses of Financial Ratios
within the Firm
• Prepare financial projections,
both at the firm and division
levels.
• Understand the financial
performance of competitors
• Evaluate the financial condition
of a major supplier.
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Uses of Financial Ratios
Outside the Firm
• Lenders in deciding whether or not to
make a loan to a company.
• Credit-rating agencies in determining
a firm’s credit worthiness.
• Investors in deciding whether or not
to invest in a company.
• Major suppliers in deciding to sell
and grant credit terms to a company.
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Measuring Key Financial
Relationships
• How liquid is the firm?
• Is management generating adequate
operating profits on the firm’s
assets?
• How is the firm financing its assets?
• Is management providing a good
return on the capital provided by the
shareholders?
• Is the management team creating
shareholder value?
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
How Liquid Is a Firm?
• Liquidity is the ability to have
cash available when needed to
meet its financial obligations
• Measured by two approaches:
– Comparing the firm’s assets that
are relatively liquid
– Examines the firm’s ability to
convert accounts receivables and
inventory into cash in a timely
basis
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Measuring Liquidity:
Approach 1
• Compare a firm’s current
assets with current liabilities
– Current Ratio
– Acid Test or Quick Ratio
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Current Ratio
• Compares cash and current assets
that should be converted into cash
during the year with the liabilities
that should be paid within the year
• Current assets/Current liabilities
Starbucks Example:
Current ratio= $922M / $591M = 1.67
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Acid Test or Quick Ratio
• Compares cash and current assets
(minus inventory) that should be
converted into cash during the year
with the liabilities that should be paid
within the year.
• Cash and accounts receivable/Current
liabilities
Starbucks Example
Quick Ratio=
($350M + $114M) / $591M =1.05
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Measuring Liquidity:
Approach 2
• Measures a firm’s ability to
convert accounts receivable
and inventory into cash
–
–
–
–
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Average Collection Period
Accounts Receivable Turnover
Inventory Turnover
Cash Conversion Cycle
Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Average Collection Period
• How long it takes to collect the firm’s
receivables
• Accounts receivable/(Annual credit
sales/365)
Starbucks Example:
Avg. Collection Period =
$114M / $1.68M= 68.1 days
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Accounts Receivable
Turnover
• How many times accounts receivable
are “rolled over” during a year
• Credit sales/Accounts receivable
Starbucks Example
Accounts Receivable Turnover =
$611M / $114M = 5.36X
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Inventory Turnover
• How many times is inventory rolled
over during the year?
• Cost of goods sold/Inventory
Starbucks Example
Inventory Turnover=
$3,207M / $342M = 9.38X
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Starbucks vs. Peer Group
Ratio
Starbucks
1.67
Peers
2.02
Quick
Ratio
1.05
1.54
Avg. Collection
Period
68.1 days
93 days
Accounts
Receivable
Turnover
5.36X
3.90X
Inventory
Turnover
9.38X
8.5X
Current
Ratio
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Is Management Generating Adequate
Operating Profits on the Firm’s
Assets?
• Operating Return on Assets
(OROA)
• Operating Profit Margin
• Total Asset Turnover
• Fixed Asset Turnover
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Operating Return on Assets
• Level of profits relative to total assets
• Operating return/Total assets
Starbucks Example
Operating Return On Assets =
$436M / $2,672M = .163 or 16.3%
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Operating Profit Margin
• Examines how effective the company
is managing its operations
• Operating profit/Sales
Starbucks Example
Operating Profit Margin =
$436M / $4,067M = .107 or 10.7%
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Total Asset Turnover
• How efficiently a firm is using its
assets in generating sales
• Sales/Total assets
Starbucks Example
Total Asset Turnover =
$4,076M / $2,672M = 1.53X
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Fixed Asset Turnover
• Examines investment in fixed assets
for sales being produced
• Sales/Fixed assets
Starbucks Example
Fixed Asset Turnover =
$4,076M / $1,750M = 2.33X
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Starbucks vs. Peer Group
Ratio
Starbucks
16.3%
Peers
14.9%
Operating Profit
Margin
10.7%
11.8%
Total Asset
Turnover
1.53X
1.26X
Fixed Asset
Turnover
2.33X
2.75X
Operating
Return on
Assets
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
How Is the Firm Financing Its
Assets?
• Does the firm finance assets
more by debt of equity?
– Debt Ratio
– Times Interest Earned
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Debt Ratio
• What percentage of the firm’s
assets are financed by debt?
• Total debt/Total assets
Starbucks Example
Debt ratio =
$591M / $2,672M = .221 or 22.1%
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Times Interest Earned
• Examines the amount of operating
income available to service interest
payments
• Operating income/Interest
Starbucks Example
Times Interest Earned =
$436M / $3M = 145.3X
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Starbucks vs. Peer Group
Ratio
Debt Ratio
Times Interest
Earned
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Starbucks
22.1%
Peers
25%
145.3X
46.0X
Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Is Management Providing a Good
Return on the Capital Provided by the
Shareholders?
• Are the earnings available to
shareholders attractive
• Return on equity
• Net income/Common equity
Starbucks Example
Return on Equity
= $268M / $208M = .129 or 12.9%
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Starbucks vs. Peer Group
Ratio
Return on
Equity
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Starbucks
12.9%
Foundations of Finance
Peers
12.0%
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
How Is Management Doing
Creating Shareholder Value?
• These ratios indicate what
investors think of
management’s past
performance and future
prospects. Two approaches:
– Price/Earnings ratio
– Price/Book ratio
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Price/Earnings Ratio
• Measures how much investors are
willing to pay for $1 of reported
earnings
• Price per share/Earnings per share
Starbucks Example
Price/Earnings Ratio =
$35.00 / $0.69 = 51X
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Price/Book Ratio
• Compares the market value of a
share of stock to the book value per
share of the reported equity on the
balance sheet
• Price per share/Equity book value per
share
Starbucks Example
Price/Book Ratio =
$35.00 / $5.32= 6.58X
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Starbucks vs. S&P Index
Price
Ratio
Price/Earnings
Ratio
Price/Book Ratio
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Starbucks
51X
S&P
24X
6.58X
3X
Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Economic Value Added (EVA)
• Measures a firm’s economic profit,
rather than accounting profit
• Recognizes a cost of equity and a cost
of debt
• EVA = (r-k) X C
where:
r = Operating return on assets
k = Total cost of capital
C = Amount of capital (Total Assets)
invested in the firm
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Limitations of Ratio Analysis
• Difficulty in identifying industry categories
or finding peers
• Published peer group or industry averages
are only approximations
• Accounting practices differ among firms
• Financial ratios can be too high or too low
• Industry averages may not provide a
desirable target ratio or norm
• Use of average account balances to offset
effects of seasonality
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Foundations of Finance
Arthur J. Keown
J. William Petty
John D. Martin
David F. Scott, Jr.
Chapter 5
The Time Value of Money
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Learning Objectives
 Explain the mechanics of
compounding, which is how money
grows over a time when it is
invested.
 Be able to move money through time
using time value of money tables,
financial calculators, and
spreadsheets.
 Discuss the relationship between
compounding and bringing money
back to present.
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Learning Objectives
 Define an ordinary annuity and
calculate its compound or future
value.
 Differentiate between an ordinary
annuity and an annuity due and
determine the future and present
value of an annuity due.
 Determine the future or present
value of a sum when there are
nonannual compounding periods.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Learning Objectives
• Determine the present value of an
uneven stream of payments
• Determine the present value of a
perpetuity.
• Explain how the international setting
complicates the time value of money.
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Principles Used in this
Chapter
• Principle 2: The Time Value of
Money – A Dollar Received Today
Is Worth More Than a Dollar
Received in The Future.
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Simple Interest
Interest is earned on principal
$100 invested at 6% per year
1st year
interest is $6.00
2nd year
interest is $6.00
3rd year
interest is $6.00
Total interest earned: $18.00
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Compound Interest
• When interest paid on an
investment during the first
period is added to the
principal; then, during the
second period, interest is
earned on the new sum.
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Compound Interest
Interest is earned on previously earned
interest
$100 invested at 6% with annual
compounding
1st year interest is $6.00 Principal is $106.00
2nd year interest is $6.36 Principal is $112.36
3rd year interest is $6.74 Principal is $119.11
Total interest earned:
$19.11
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Future Value
- The amount a sum will grow in
a certain number of years when
compounded at a specific rate.
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Future Value
FV1 = PV (1 + i)
Where FV1 = the future of the investment at
the end of one year
i= the annual interest (or discount)
rate
PV = the present value, or original
amount invested at the beginning
of the first year
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Future Value
What will an investment be worth
in 2 years?
$100 invested at 6%
FV2= PV(1+i)2 = $100 (1+.06)2
$100 (1.06)2 = $112.36
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Future Value
• Future Value can be increased
by:
• Increasing number of years of
compounding
• Increasing the interest or
discount rate
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Future Value Using Tables
FVn = PV (FVIFi,n)
Where FVn = the future of the investment at
the end of n year
PV = the present value, or original
amount invested at the beginning
of the first year
FVIF = Future value interest factor or
the compound sum of $1
i= the interest rate
n= number of compounding periods
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Future Value
What is the future value of $500
invested at 8% for 7 years? (Assume
annual compounding)
Using the tables, look at 8% column, 7
time periods. What is the factor?
FVn= PV (FVIF8%,7yr)
= $500 (1.714)
= $857
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Future Value Using Calculators
Using any four inputs you will find the 5th.
Set to P/YR = 1 and END mode.
INPUTS
N
10
PV
-100
PMT
0
FV
179.10
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OUTPUT
I/YR
6
Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Future Value Using Spreadsheets
Spreadsheets and the Time Value of Money
If we invest $500 in a bank where it will earn 8 percent compounded
annually, how much will it be worth at the end of 7 years?
rate (I) =
number of periods (n) =
payment (PMT) =
present value (PV) =
type (0=at end of period) =
Future value =
8%
7
0
$500
0
$856.91
Excel formula: FV = (rate, number of periods, payment, present value, type)
Entered in cell d13: = FV(d7,d8,d9,-d10,d11)
Notice that present value ($500) took a negative value
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Present Value
The current value of a future payment
PV = FVn {1/(1+i)n}
Where FVn = the future of the investment at
the end of n years
n= number of years until payment is
received
i= the interest rate
PV = the present value of the future sum
of money
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Present Value
What will be the present value of $500
to be received 10 years from today if
the discount rate is 6%?
PV = $500 {1/(1+.06)10}
= $500 (1/1.791)
= $500 (.558)
= $279
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Present Value Using Tables
PVn = FV (PVIFi,n)
Where PVn = the present value of a future sum of
money
FV = the future value of an investment at
the end of an investment period
PVIF = Present Value interest factor of $1
i= the interest rate
n= number of compounding periods
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Present Value
What is the present value of $100
to be received in 10 years if the
discount rate is 6%?
PVn = FV (PVIF6%,10yrs.)
= $100 (.558)
= $55.80
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Present Value Using Calculators
Using any four inputs you will find the 5th.
Set to P/YR = 1 and END mode.
INPUTS
N
10
I/YR
6
PMT
0
FV
100.00
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OUTPUT
PV
-55.84
Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Annuity
• Series of equal dollar payments
for a specified number of years.
• Ordinary annuity payments
occur at the end of each period
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Compound Annuity
• Depositing or investing an equal
sum of money at the end of
each year for a certain number
of years and allowing it to grow.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Compound Annuity
FV5 = $500 (1+.06)4 + $500 (1+.06)3
+$500(1+.06)2 + $500 (1+.06) + $500
= $500 (1.262) + $500 (1.191) +
$500 (1.124) + $500 (1.090) +
$500
= $631.00 + $595.50 + $562.00 +
$530.00 + $500
= $2,818.50
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Illustration of a 5yr $500 Annuity
Compounded at 6%
0
1
2
3
4
5
500
500
500
500
500
6%
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Future Value of an Annuity
FV = PMT {(FVIFi,n-1)/ i }
Where FV n= the future of an annuity at
the end of the nth years
FVIFi,n= future-value interest factor or sum of
annuity of $1 for n years
PMT= the annuity payment deposited or
received at the end of each year
i= the annual interest (or discount) rate
n = the number of years for which the
annuity will last
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Compounding Annuity
What will $500 deposited in the bank
every year for 5 years at 10% be
worth?
FV = PMT {(FVIFi,n-1)/ i }
Simplified this equation is:
FV5 = PMT(FVIFAi,n)
= $500(5.637)
= $2,818.50
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Future Value of an Annuity
Using Calculators
Using any four inputs you will find the 5th.
Set to P/YR = 1 and END mode.
INPUTS
N
5
PV
0
I/YR
6
PMT
500
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OUTPUT
FV
-2,818.55
Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Present Value of an Annuity
• Pensions, insurance obligations,
and interest received from
bonds are all annuities. These
items all have a present value.
• Calculate the present value of
an annuity using the present
value of annuity table.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Present Value of an Annuity
Calculate the present value of a $500
annuity received at the end of the
year annually for five years when the
discount rate is 6%.
PV = PMT(PVIFAi,n)
= $500(4.212)
= $2,106
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Annuities Due
• Ordinary annuities in which all
payments have been shifted
forward by one time period.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Amortized Loans
• Loans paid off in equal
installments over time
– Typically Home Mortgages
– Auto Loans
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Payments and Annuities
If you want to finance a new
machinery with a purchase
price of $6,000 at an interest
rate of 15% over 4 years, what
will your payments be?
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Future Value Using Calculators
Using any four inputs you will find the 5th.
Set to P/YR = 1 and END mode.
INPUTS
N
4
PV
6,000
I/YR
15
FV
0
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OUTPUT
PMT
-2,101.59
Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Amortization of a Loan
• Reducing the balance of a loan via
annuity payments is called
amortizing.
• A typical amortization schedule
looks at payment, interest, principal
payment and balance.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Amortization Schedule
Yr.
Annuity
Interest Principal
1
$2,101.58
$900.00 $1,201.58 $4,798.42
2
$2,101.58
719.76
1,381.82
3,416.60
3
$2,101.58
512.49
1,589.09
1,827.51
4
$2,101.58
274.07
1,827.51
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Foundations of Finance
Balance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Compounding Interest with
Non-annual periods
If using the tables, divide the percentage by
the number of compounding periods in a
year, and multiply the time periods by the
number of compounding periods in a year.
Example:
8% a year, with semiannual compounding for
5 years.
8% / 2 = 4% column on the tables
N = 5 years, with semiannual compounding
or 10
Use 10 for number of periods, 4% each
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Perpetuity
• An annuity that continues forever is
called perpetuity
• The present value of a perpetuity is
PV = PP/i
PV = present value of the perpetuity
PP = constant dollar amount
provided by the of perpetuity
i = annuity interest (or discount
rate)
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
The Multinational Firm
• Principle 1- The Risk Return Tradeoff – We
Won’t Take on Additional Risk Unless We
Expect to Be Compensated with Additional
Return
• The discount rate is reflected in the rate of
inflation.
• Inflation rate outside US difficult to predict
• Inflation rate in Argentina in 1989 was
4,924%, in 1990 dropped to 1,344%, and in
1991 it was only 84%.
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Foundations of Finance
Pearson Prentice Hall