Cameron School of Business
UNIVERSITY OF NORTH CAROLINA WILMINGTON
An Introduction to
Finance:
Chapters 1 – 3 of
Essentials of Corporate
Finance
Edward Graham
Professor of Finance
Department of Economics and
Finance
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Outline of the Introduction to Finance Module
Introduction to Finance
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I.
The Three Primary Duties of the Financial Manager
II.
Evidence of the Results of Financial Decision-making: The
Financial Statement and Ratio Analysis
An Introduction to Finance
What is finance?
• Finance is the study of the art and the science of money
management; it is based on the Latin root finis,
meaning the end. In managing ours or our firm’s money,
we consider historical outcomes or “endings,”
and we propose future results as a function of decisions
made today. Those outcomes or results are
typically portrayed using financial statements.
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I.
The Three Primary Duties of the
Financial Manager
Whether managing monies for the home, or for the firm, our
duties are met with decisions framed by the same general
principles. These principles instruct us in making three main
types of decisions as we perform those three primary duties:
•The capital budgeting decision
•The capital structure decision
•The working capital decision
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The Capital Budgeting Decision
With the capital budgeting decision, the financial manager
decides where best to deploy monies long-term. The
purchase of a new delivery truck or a new warehouse
is a capital budgeting decision; the payment of a utility
bill is not.
With the making of this decision, we consider three features
of the cash flows deriving from the decision:
• The size of the cash flows
• The timing of the cash flows
• The risk of the cash flows
We review a couple examples of capital budgeting decisions.
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The Capital Structure Decision
With the capital structure decision, the financial manager decides
from where best to acquire monies long-term. The purchase of that
new delivery truck with cash or with a loan from GMAC or Ford
Motor Credit is a capital structure decision; the use of long-term
borrowing to fund a franchise purchase is another.
Perhaps most importantly, the decision to fund a firm’s growth with
equity - such as with funds invested by the firm’s founders, angel
investors, venture capitalists or public stock offerings – or debt, is
a critical capital structure choice. Two features of this choice bear
mentioning:
• The risk of the debt
• The loss of control and reduced potential cash flows to the
founders with an equity or stock sale
We expand our review with a few capital structure decisions.
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The Working Capital Decision
With the working capital decision, current assets and current
liabilities become the focus of the financial manager.
Such items as cash balances, accounts receivable, inventory levels
and short-term accruals (such as prepaid rent or utilities) are
included among the short-term assets that comprise one
component of working capital.
Also with the working capital decision, we concern ourselves with
short-term obligations such as accounts payable to vendors,
and other debt that is expected to be paid off within one year.
Net working capital is a meaningful outcome of the working capital
decision-making matrix. Net working capital is merely the
difference between current assets and current liabilities.
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II.
Evidence of the Results of Financial Decisionmaking: The Financial Statement and Ratio
Analysis
Providing valid and timely information to the varied
stakeholders in the firm is key. These stakeholders, both
within and outside the firm, include the owners, the
employees, neighbors, the community-at large, suppliers,
lenders, bankers, and the competition.
This information is typically provided within financial
statements, and notes to those statements. Three
statements attract our attention:
• The Income Statement
• The Statement of Cash Flows
• The Balance Sheet
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Ratio Analysis
Five types of ratios support our discussion, and underscore
important features of the information we are providing our
varied stakeholders:
•
•
•
•
•
Short term solvency
Long term solvency
Asset management
Profitability
Market value
We briefly discuss each of these in turn, with examples of
each type of ratio drawn from your earlier work in
accounting, and illustrated by the example in class.
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The Example in Class, Inc.
Balance Sheet at Year’s End
Assets
Current Assets
Cash
Receivables
Inventory
Total Current Assets
50,000
20,000
30,000
100,000
Fixed Assets
150,000
Total Assets
250,000
Liabilities & Owner’s Equity
Current Liabilities
Payables
50,000
Total C/Liabilities
50,000
Long Term Liab.
Total Liabilities
100,000
150,000
Owner’s Equity
Par Value
APIC
Ret. Earnings
Total Owner’s Eq.
10,000
40,000
50,000
100,000
Total Liab and O/E 250,000
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The Example in Class, Inc.
• Short Term Solvency Ratios
– Current Ratio: current assets/current liabilities = 100,000/50,000 = 2
– Quick Ratio: (current assets – inventories)/current liabilities
» = (100,000 – 30,000)/50,000 = 1.4
• Long Term Solvency (or Debt) Ratios
– Debt Ratio: total liabilities/total assets = 150,000/250,000 = .6
– Debt-to-Equity Ratio: total debt/total equity = 150,000/100,000 = 1.5
– Equity Multiplier: total assets/total equity = 250,000/100,000 = 2.5
What is the meaning of the each of the metrics? For example, what does
a current ratio of “2” really mean? The quick ratio? The Long Term
Solvency measures?
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The Example in Class, Inc.
•
Assume our firm had sales in the most recent year of $200,000 and Net Income
of $20,000.
•
EIC, Inc. has 10,000 shares outstanding. Those shares were initially issued for
$5 each with a par value of $1 per share. With net income of $20,000, EPS or
Earnings Per Share becomes 20,000/10,000 or $2. Book value per share is total
equity divided by shares outstanding or 100,000/10,000 or $10 per share.
•
Dividends were $1 per share or a total of $10,000. Thus, the firm paid out 50%
of earnings (dividends paid/net income = the dividend payout ratio of
10,000/20,000 or 50%)
• Asset Utilization Ratios
– Total Asset Turnover: sales/total assets = 200,000/250,000 = .8
– Average Age of Receivables: 365 days/(sales/accounts receivable)
» = 365 days/(200,000/20,000) = 36.5 days
And how best might we interpret these asset utilization ratios?
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The Example in Class, Inc.
• Profitability Ratios
– Profit Margin: net income/sales = 20,000/200,000 = .1
– Return on Assets (ROA): net income/total assets
» = 20,000/250,000 = .08
– Return on Equity (ROE): net income/owner’s equity
» = 20,000/100,000 = .20
Now assume EIC has a stock price of $40 per share
Earnings per share (EPS) was $2 or 20,000/10,000
(net income/shares outstanding)
Book value per share was 100,000/10,000 or $10
(owner’s equity/shares outstanding)
• Market Value Ratios
– Price-Earnings ratio: price per share/EPS = 40/2 = 20
– Market-to-Book ratio: price per share/book value per share = 40/10 = 4
How do we interpret these final financial ratio examples?
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The Example in Class, Inc.
• The DuPont Identity:
ROE = PM x T/A T/O x EM
or
ROE = NI/Sales x Sales/Total Assets x Total Assets/Equity
=(20,000/200,000) x (200,000/250,000) x (250,000/100,000)
NI/Sales reflects the impact of operations
Sales/Total Assets reflects the impact of the capital
budgeting decision
Total Assets/Equity reflects the impact of the capital
structure decision
For EIC: ROE = (.10) x (.8) x (2.5) = .20, as before.
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