An Overview of Finance
Areas within Finance
Investments and financial markets
Financial management of corporations
Fields are separate but related
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Financial Assets
Real asset—Objects that provide services: houses, cars,
food, etc.
Financial asset—a document representing a claim to future
income
– Stock represents ownership interest
– Bond represents a debt relationship
Investing involves buying financial assets in the hope of
earning more money (a return)
– Investments can be made directly or indirectly through a mutual
fund
A Security is a financial asset that can be traded among
investors
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Financial Markets
Securities are issued by corporations to
raise money, and purchased by investors
in financial markets
– A framework or organization in which people
can buy/sell securities
Stock market
Stockbroker is licensed to trade
securities
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Simplified Financial System
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Raising Money
The most common use of the word
finance involves raising money to
acquire assets
Forms of Financing
– Issuing stock - equity financing
– Borrowing money - debt financing
– Internal financing - retaining earnings
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Raising Money
The field of finance deals with both
raising and investing money, but:
Changing Focus of Finance
– Past - finance was limited to financial
market activity
– Now – Corporate finance includes the
financial management of organizations
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Financial Management
The management and control of money
and money-related operations within a
business
CFO – chief financial officer (VP of
finance)
– Executive in charge of finance department
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Financial Management
Functions of the finance department:
– Keeping records
– Receiving payments from customers
– Making payments to suppliers
– Borrowing money
– Purchasing assets
– Selling stock
– Paying dividends
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Business Decisions
Finance department provides:
– Analyses to determine which assets are
purchased and how they are financed
– Oversight of how other departments
spend money
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The Price of Securities—A Link
Between the Firm and the Market
Two sides of finance – investments and
financial management
Investors buy securities for the cash
income expected in the future
Link between company management and
investors comes from this relationship
between price and expected financial
results
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Accounting and Finance
Broad Portrayal vs. Cash Flow
Accounting statements
portray physical activity in
numbers
– Descriptive
– Historical
E.g. Depreciation
The focus in Finance
is on future cash flow
In finance:
Cash is King
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Finance and Accounting
Finance department generally consists of
both the accounting and treasury
departments
– Controller is in charge of the
accounting department
– Treasury department deals with
other other financial activities
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Figure 1-2 Finance Department Organization
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Concept Connection Example 1-1
Accounting Records and Cash Flow
A $1,000 asset depreciated straight-line over five years:
Accounting perspective – Portrait Over Time
Initial $1,000 cost becomes an asset on books
$200 per year depreciation reduces profit
Book value shrinks as depreciation accumulates
Finance perspective – Focus On Cash Flow
Depreciation deduction saves cash by reducing tax
It took a $1,000 cash outflow to acquire the asset
Where did the money come from
Finance had to raise that money
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The Language of Finance
Accounting is the language of finance
– All finance professionals need some
knowledge of accounting
Level depends on job
– Financial analyst needs to know LOTS of accounting
– Stockbrokers not as much
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Financial Theory—The Relationship with
Economics
Modern financial theory began as a
branch of economics in the 1950s
– Originally called “financial economics”
– Theoretical tools are very similar
Finance is a separate but still related
field
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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 Impact
A businesses can be legally organized as a
– sole proprietorship
– partnership
– corporation
Legal organization has an impact on
– Raising money
– Taxation
– Financial liability
For our purposes we’ll combine partner/proprietor
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The Proprietorship Form
Easy to start
Taxes
– Profit is taxed as personal income
Taxed only once
Raising money – Investor’s perspective
– A proprietorship can only borrow (no stock to sell)
But lending money to a new business is risky
– Best outcome: repayment of principal and interest
– Worst outcome: lose everything
– Most new businesses fail
Result: Collateral required
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The Corporate Form
Getting started
– Requires a legal incorporation process
Takes a little time, work and money
Taxes
– Double taxation
Corporation pays corporate taxes on income
Dividends paid to owners are taxed as
personal income
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Concept Connection Example 1-2 Tax
Consequences of Business Form
A business earns $100,000 before taxes.
Owner wants to take the earnings home.
Tax rates: Corporate - 34%
Personal - 30%
Compare total tax bills under corporate and proprietorship forms of
organization
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The Corporate Form
Raising Money
– Borrowing
– Same issues faced by sole proprietorship
– BUT owner can now offer stock (equity) to investors
– If sell less than 50% can maintain control
– From the investor’s perspective
– Stock is a risky investment but the reward may be worth it
» Worst possible outcome: lose entire investment
» Best possible outcome: get rich
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The Truth About Limited Liability
Limited liability: stockholder not liable for a
corporation’s debts
– Implies that the most a stockholder can lose is 100%
of his investment in the stock
– True for owners not involved in the business
However, for owner operated small businesses
– Personal guarantees make entrepreneurs liable for
loans to their businesses
– Legal system holds individuals liable for negligence
– These destroy the value of limited liability
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S-Type Corporations and LLCs
Major advantage: Treated as a partnership
with respect to federal income taxes
– LLC is replacing S-type
Government encourages small businesses
because they create jobs
– S-type corporations and LLCs
Avoid double taxation: profits “pass through” to owners as
personal income
Offer limited liability
Offer the ability to sell stock to raise money
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Goals of Management
Economics—goal is to maximize profit
– Runs into short/long run problems
– Example: What about R&D?
Finance—goal is to maximize stockholders’
wealth by maximizing stock price
– Investors take a broad look at corporate actions
when bidding stock prices up or down
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Stakeholders and Conflicts of Interest
Stakeholders that have an interest in the way
the firm is operated include:
Stockholders
Employees
Customers
Community
Management
Creditors
Suppliers
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Conflicts of Interest
An Illustration
Employees want management to build
a gym
– Benefit — healthy employees are more
productive
– Cost — reduces stockholders’ return
Conflict of interest between
stockholders and employees
– What if request for healthier working
conditions?
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Management—A Privileged Stakeholder
Group
Ownership of a widely held companies is very
dispersed so no one has enough control to remove
management
Top management becomes entrenched controlling
corporate resources
They can use those resources for their own benefit
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The Agency Problem
Conflict of interest between stockholders and
management
– Agent is hired by a principal and given decision-making
authority
The Abuse of Agency
– Privileges and luxuries provided to executives - ‘perks’
Controlling the Agency Problem
– Manage the agency problem by:
Monitoring management (audits)
Tying executive compensation to stock performance
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Creditors Versus Stockholders—A
Financially Important Conflict of Interest
Creditor - anyone owed money by a business
– Especially bondholders
If undertake high risk - high reward projects:
– Losses shared by both stockholders and
bondholders
– But risk taking rewards all go to stockholders
Bondholders receive only principal and interest
Loan agreements can be written to prevent this kind
of abuse
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