1 CHAPTER 1: Introduction to Financial Management 1. Corporate Finance – Business Finance 2. Investments (4) Areas of Finance 3. Financial Institutions 4. International Finance - area of finance that deals with sources of funding, capital structure, and actions to increase the value of the firm - is a broad description of the planning, management, and control of a company's money. - includes working capital management, financial statement analysis, cash budgeting, capital budgeting, and more. In a small business, the owner/manager conducts the daily financial operations of the company. In larger businesses, daily finance decisions may be made by the owner/manager, along with a finance Corporate Finance – Business Finance committee. Larger financial transactions may need to be approved by the Board of Directors of the firm. - includes the management of the following areas of the finance function: • Working Capital Management • Cash Budgeting • Financial Analysis • Financial Statement Development • Capital Budgeting • Dividend Policy - deals with financial assets such as stocks and bonds - or the investment decision, which also involves the financial markets and financial institutions. This type of marketplace and company, respectively, makes easy transfer of money possible when investments are made. - Here are some examples of investments that a small business may make. • Stocks - Businesses can invest in the stocks, or equity securities, of other businesses. The return may include dividends and capital gains. • Bonds - Businesses can invest in the bonds, or debt securities, issued by other Investments companies. The return will include the return of the principal at maturity and interest payments. • Marketable Securities - These are short-term, liquid investments, usually made at a bank or other financial institution, that have a maturity of one year or less. • Commodities - Commodities are products with relatively volatile price swings, like pork bellies or coffee. Their prices rise and fall rapidly. • Derivatives - Derivatives are products from adjacent markets. The trade is conducted in the form of a contract between two parties, and the value of the derivative is based on the value of the original investment. - businesses that deal primarily in financial matters - is a company engaged in the business of dealing with financial and monetary transactions such as deposits, loans, investments, and currency exchange. - encompass a broad range of business operations within the financial services sector including banks, trust companies, insurance companies, brokerage firms, and investment dealers. - types of financial institutions: • Commercial Banks - is a type of financial institution that accepts deposits, offers checking account services, makes business, personal, and mortgage loans, and offers basic financial products like certificates of deposit (CDs) and savings accounts to individuals and small businesses • Investment Banks - specialize in providing services designed to facilitate business Financial Institutions operations, such as capital expenditure financing and equity offerings, including initial public offerings (IPOs). • Insurance Companies - among the most familiar non-bank financial institutions are insurance companies. Providing insurance, whether for individuals or corporations, is one of the oldest financial services. • Brokerage Firms - Investment companies and brokerages, such as mutual fund and exchange-traded fund (ETF) provider Fidelity Investments, specialize in providing investment services that include wealth management and financial advisory services. They also provide access to investment products that may range from stocks and bonds all the way to lesser-known alternative investments, such as hedge funds and private equity investments. International Finance Marketing - international aspect of first 3 areas. - an area of specialization - sometimes known as international macroeconomics, is the study of monetary interactions between two or more countries, focusing on areas such as foreign direct investment and currency exchange rates. International finance deals with the economic interactions between multiple countries, rather than narrowly focusing on individual markets. Importance of Finance – Why Study Finance? - marketers work with budgets, marketing research, and cost-benefit analyses - marketing financial services require finance knowledge a. Financial Management Provides Funds for the Right Campaign at the Right Time - by keeping a check on various marketing spends, a financial manager can save funds on marketing investments that matter. 2 b. Accounting Management You Financial Manager Chief Financial Officer (CFO) Treasurer Controller Capital Budgeting Capital Structure Working Capital Sole Proprietorship Partnership Corporation Financial Management Helps Keep Marketers on a Budget - financial managers can help forecast the marketing spends and plan for various marketing elements. They also help the marketing team in compliance of the best practices in accounting. c. Financial Management Adds Financial Acumen to Creativity - financial management enables marketing and advertising function to stay on track, manage the financial aspects of business accurately and avoid any financial blunders that may cost the company - implications of many of the newer types of financial contracts on financial statements - understand what is valuable and how accounting knowledge is used a. Financial implications in business plans – management need to know the financial needs for business planning. b. Management roles should be aware of their effect is profitability – the financial implications or costs of business plans affects the profitability of the entity. - personal finance - everyday financial decisions The Financial Manager - they try to answer some or all the corporate finance questions. - top financial manager within a firm - oversees cash management, credit management, capital expenditures, and financial planning - in custody of assets - highest accounting related position in an organization - oversees taxes, cost accounting, financial accounting, and data processing - concerned with the recording of financial assets Financial Management Decisions - process of planning and managing a firm’s long-term investment - cash flow generated > cost of asset - evaluating the size, timing, and risk of cash flows - What long-term investments or projects should the business take on? - mixture of debt and equity maintained by the firm - how much to borrow, what to borrow, and where to borrow - How should we pay for our assets? - Should we use debt or equity? - firm’s short-term assets and liabilities - sufficient resources to continue operations and avoid costly interruptions - How do we manage the day-to-day finances of the firm? - business owned by a single individual - most small businesses start out as sole proprietorships. - are owned by one person, usually, the individual who has day-to-day responsibility for running the business. - can be independent contractors, freelancers, or home-based businesses. Advantages Disadvantages • Easiest to start and least expensive • Limited to life of owner form of ownership to organize • Equity capital limited to owner’s • Least regulated (owner makes all personal wealth (Limited in raising decisions and is in complete control funds and may have to acquire of the company; could also be a consumer loans) disadvantage) • Unlimited liability • Single owner keeps all of the profits • Difficult to sell ownership interest • Taxed once as personal income • No separate legal status - business formed by two or more individuals or entities - two or more people share ownership of a single business. - like proprietorships, the law does not distinguish between the business and its owners. - the partners should have a legal agreement that sets forth how decisions will be made, profits will be shared, disputes will be resolved, how future partners will be admitted to the partnership, how partners can be bought out or what steps will be taken to dissolve the partnership when needed. Disadvantages Advantages • Unlimited Liability • Two or more owners (partners may ✓ General Partnership have complementary skills) ✓ Limited Partnership • More capital available • Profits must be shared with the • Relatively easy to start (with the partners. exception of developing a • Divided decision making partnership agreement) • Partnership dissolves when one • Income taxed once as personal partner dies or wishes to sell income • Difficult to transfer ownership • Separate legal status to give liability • Business can suffer if the detailed protection. partnership agreement is not in place - business created as a distinct legal entity owned by one or more individuals or entities - is considered by law to be a unique entity, separate from those who own it. 3 - can be taxed, sued, and enter into contractual agreements. The corporation has a life of its own and does not dissolve when ownership changes. - Three types of Corporations: 1. C-corporation - is a corporation that is taxed separately from its owners. It gives the owners limited liability encouraging more risk-taking and potential investment. Advantages Disadvantages • Limited liability • Double taxation (corporation • Transfer of ownership, and shareholder earnings taxed) shareholders can sell their shares. • Can be costly to form. • Capital is easier to raise through • More administrative duties the sale of stock. required by law to have annual • Company paid fringe benefits. meetings, notify stockholders of • Tax benefits the meeting, must keep minutes of meetings, and turn in. • Pay corporate taxes at a different time than other forms of business 2. • • • • • 3. S-Corporation - also known as subchapter S-corporation offers limited liability to the owners. S-corporations do not pay income taxes rather the earnings and profits are treated as distributions. The shareholders must report their income on their individual income tax returns Advantages Disadvantages Limited liability • Can be costly to form. Avoids double taxation. • Stockholders limited to Profits taxed only once. individuals, estates, or trustees. Capital is easier to raise through • Required administrative duties. the sale of stock. • Cannot provide company paid Transfer of ownership. fringe benefits. • Stockholders are limited to citizens or resident aliens of the United States. Limited Liability Company (LLC) - is a hybrid business structure that provides the limited legal liability of a corporation and the operational flexibility of a partnership or sole proprietorship. However, the formation is more complex and formal than that of a general partnership. Advantages Disadvantages • Most common business structure • Can be costly to form. and specifically created for small • Yearly administrative costs. businesses. • Personal tax liability. • Must have insurance in case of a • Legal and accounting suit. assistance is recommended. • Separate legal entity. • Usually taxed as a sole proprietorship. • Unlimited number of owners Advantages • Limited Liability Disadvantages • Unlimited Life • Separation of ownership and • Separation of ownership and management management • Double Taxation • Transfer of ownership is easy • Easier to raise capital Goal of Business Finance/Corporate Finance - goal of financial management - For any business, it is important that the finance it procures is invested in a manner that the returns from the investment are higher than the cost of finance. In a Maximize the market value of the existing nutshell, financial management – owner’s equity • Endeavors to reduce the cost of finance. • Ensures sufficient availability of funds. • Deals with the planning, organizing, and controlling of financial activities like the procurement and utilization of funds. - intended to strengthen protection against accounting fraud and financial malpractice Sarbanes-Oxley Act of 2002 - compliance very costly - firms driven to: Go public outside the U.S. or Go private (“go dark”) Agency Theory - relationship between stockholders and management - is a principle that is used to explain and resolve issues in the relationship between Agency Theory business principals and their agents. Most commonly, that relationship is the one between shareholders, as principals, and company executives, as agents. Agency Relationship - relationship between stockholders and management - is any relationship between two parties in which one, the agent, represents the Agency other, the principal, in day-to-day transactions. The principal or principals have hired the agent to perform a service on their behalf 4 Principals Agent Agency Problem (Principal-Agent Problem) Agency Costs Managerial Compensation Control of the Firm - delegate decision-making authority to agents. Because many decisions that affect the principal financially are made by the agent, differences of opinion, and even differences in priorities and interests, can arise. - is using the resources of a principal. The principal has entrusted money but has little or no day-to-day input. - is the decision-maker but is incurring little or no risk because any losses will be borne by the principal - possibility of conflict of interest between the owners and management of a firm (goal incongruence) - agency theory assumes that the interests of a principal and an agent are not always in alignment. - costs incurred as a result of agency (conflict of interest) Managers and the Stockholder’s Interest • Compensation tied to financial performance/share value • Best performers within the firm get promoted/can demand higher salaries ✓ Proxy Fight – mechanism by which unhappy stockholders can act to replace management ✓ Takeover – acquisition of a firm by another firm ✓ Stakeholders – someone other than the stockholder or creditor who potentially has a claim on the cash flows of the firm Financial Markets and the Corporation A. Firm issues securities to raise cash B. Firm invests in assets C. Firm’s operations generate cash flow D. Cash is paid to government as taxes. Other stakeholders may receive cash. E. Reinvested cash flows are plowed back into firm F. Cash is paid out to investors in the form of interest and dividends Primary Markets Secondary Markets Auction Markets Dealer Markets Financial Markets - original sale of securities - the corporation/government is the seller - is where securities are created. - it is in this market that firms sell (float) new stocks and bonds to the public for the first time. - these trades provide an opportunity for investors to buy securities from the bank that did the initial underwriting for a particular stock. - an initial public offering, or IPO, is an example of a primary market. An IPO occurs when a private company issues stock to the public for the first time. - securities are ought and sold after the original sale - involves one owner to another - for buying equities, the secondary market is commonly referred to as the "stock market." • Auction Markets • Dealer Markets • Over-the-counter Markets - unlike dealer markets, has physical location - primary purpose is to match those who wish to sell with those who wish to buy - in the auction market, all individuals and institutions that want to trade securities congregate in one area and announce the prices at which they are willing to buy and sell. - these are referred to as bid and ask prices. The idea is that an efficient market should prevail by bringing together all parties and having them publicly declare their prices. - market where a dealer buys and sells for themselves - in contrast, a dealer market does not require parties to converge in a central location. Rather, participants in the market are joined through electronic networks. 5 Over-the-counter Markets - the dealers hold an inventory of security, then stand ready to buy or sell with market participants. These dealers earn profits through the spread between the prices at which they buy and sell securities. - dealer markets in stocks and long-term debt - nowadays, the term "over-the-counter" generally refers to stocks that are not trading on a stock exchange. CHAPTER 10: Some lessons from Capital Market History • The risk-return tradeoff is an investment principle that indicates that the higher the risk, the higher the potential reward. • To calculate an appropriate risk-return tradeoff, investors must consider many Understanding Risk-Return Tradeoff factors, including overall risk tolerance, the potential to replace lost funds and more. • Investors consider the risk-return tradeoff on individual investments and across portfolios when making investment decisions. - uncertainties involved in the investment we are opting to undertake Risk - higher risks have higher returns Return - inflows we expect from taking risks Return on Investment - gain (or loss) from your investment (e.g., if you buy an asset) Income Component - cash received directly while you own the investment - change in value of the investment you purchased Capital Gain (Loss) - realized when you sell a stock - sum of dividend income and capital gain (loss) Total Dollar Return - on a nondollar investment, which includes the sum of any dividend/interest income, capital gains or losses, and currency gains or losses on the investment. - dividend as a percentage of the beginning stock - expressed as a percentage, is a financial ratio (dividend/price) that Dividend Yield shows how much a company pays out in dividends each year relative to its stock price. - the reciprocal of the dividend yield is the price/dividend ratio. - change in price during the year divided by the beginning price - is the percentage price appreciation on an investment. Capital Gains Yield - it is calculated as the increase in the price of an investment, divided by its original acquisition cost. 1. Stocks 2. Bonds (3) Financial Investments 3. Treasury Bills The Historical Record • • The Historical Record - Observations Small company investment did best over-all T-bills and Government bonds grew more slowly, but they also grew more steadily - add-up yearly returns over the years observed - ex. small cap ave. return 16.7% - 3.5% t-bills ave. return (risk free return) = 13.2% - risk-free return - type of debt that is virtually free of any default risk - risk premium – excess return required from an investment in a risky asst over that required from a risk-free investment Average Returns There is a REWARD for bearing RISK Frequency Distribution Variance - first lesson Variability of Returns - number of instances in which a variable takes each of its possible values - average squared differences between the actual return and the average return - the bigger the variance, the more actual returns differ from average returns 6 Standard Deviation Normal Distribution The greater the potential REWARD, the greater is the RISK Geometric Average Return - the positive square root of the variance - a way to understand more of the variance - symmetric, bell-shaped frequency distribution that is completely defined by its average and standard deviation - second lesson Average Returns - it is a more useful for long-term periods. - average compound return earned per year over a multiyear period - what was your average compound return per year over a particular period? - it is a more useful for short-term periods - return earned in an average year over a particular period - what was your return in an average year over a particular period? Arithmetic Average Return Efficient Capital Market Efficient Market Hypothesis Efficient Market Reaction Delayed Reaction Overreaction and correction Capital Market Efficiency - market in which security prices reflect available information - hypothesis that actual capital markets are efficient - price instantaneously adjusts to and fully reflects new information - there is no tendency for subsequent increases and decreases - price partially adjusts to the new information - eight days elapse before the price completely reflects the new information - price over adjusts to the new information - it overshoots the new price and subsequently correct Forms of Market Efficiency - all information of every kind is reflected in stock prices - all public information is reflected in the stock price - the current price of a stock reflects its own past prices ✓ EMH does not mean that you can’t make money ✓ On average, you will earn a return appropriate for the risk undertaken Efficient Market Hypothesis Misconception ✓ There is no bias in prices that can be exploited to earn excess returns ✓ Market efficiency will not protect you from wrong choices if you do not diversify Capital Market History • Prices do no appear to respond very rapidly to new information, and the response is at least not grossly different from what we would expect in an efficient market • The future of market prices, particularly in the short run, is very difficult to predict based on publicly available information • If mispriced stocks do exist, then there is no obvious means of identifying them Strong Form Efficiency Semi-strong Form Efficiency Weak Form Efficiency Capital Gains 𝐶𝐺 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 − 𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 Total Peso Return 𝑇𝑃𝑅 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛𝑠 SUMMARY OF FORMULAS Capital Gains Yield 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 − 𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝐶𝐺 = 𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 Dividend Yield 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒 Total Percentage Return 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛𝑠 𝑇𝑃𝑅% = 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑟 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 7 Standard Deviation 𝑺𝟐 = √𝑺 Variance ∑(𝒙 − 𝒙 ̅ )𝟐 𝑺𝟐 = 𝒏−𝟏 To Square a number Press “x” sign twice, then press “=” to get n2 For odd exponents, after pressing “x” twice and once for “=”, press 1 and use = for # times to get desired exponent Arithmetic Average ∑ 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 𝐴𝐴 = 𝑛 Geometric Average 𝐺𝐴𝑅 = [(1 + 𝑥1 ) ∙ (1 + 𝑥2 ) … (1 + 𝑥𝑛 )]−1/𝑛 − 1 Interpolation (1 + 𝑖)4 − 𝐿𝑜𝑤𝑒𝑟 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑜𝑓 𝑖𝑛𝑛𝑒𝑟 = 𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑜𝑓 𝑜𝑢𝑡𝑒𝑟 𝐻𝑖𝑔ℎ𝑒𝑟 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 − 𝐿𝑜𝑤𝑒𝑟 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 Using Square Root Function Compute for (1 + 𝑖)4 , then press √ key Fisher Equation (1 + 𝑖) = (1 + 𝑟)(1 + 𝜋) Where i = normal interest r = real interest or risk-free interest π = inflation 1 1st √ key = 𝑛2 2nd √ key = 𝑛4 1
