Revised by Dr. Nelson v.k. Wong CPA
McGraw-Hill/Irwin
Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.
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Key Concepts and Skills
Have a good understanding of:
• The basic types of financial management
decisions and the role of the financial
manager
• The goal of financial management
• The financial implications of the different
forms of business organization
• The conflicts of interest that can arise
between owners and managers
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Chapter Outline
RWJ website
1.1 Finance: A Quick Look
1.2 Business Finance and The Financial
Manager
1.3 Forms of Business Organization
1.4 The Goal of Financial Management
1.5 The Agency Problem and Control of
the Corporation
1.6 Financial Markets and the Corporation
1.7 Financial reports and their standards
1-4
Basic Areas Of Finance
1.
2.
3.
4.
Corporate finance = Business Finance
Investments
Financial institutions
International finance
Return to
Quick Quiz
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Investments
• Work with financial assets such as stocks
and bonds
• Value of financial assets, risk versus
return, and asset allocation
• Job opportunities
– Stockbroker or financial advisor
– Portfolio manager
– Security analyst
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Financial Institutions
• Companies that specialize in financial
matters
– Banks – commercial and investment, credit
unions, savings and loans
– Insurance companies
– Brokerage firms
• Job opportunities
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International Finance
• An area of specialization within each of
the areas discussed so far
• May allow you to work in other countries
or at least travel on a regular basis
• Need to be familiar with exchange rates
and political risk
• Need to understand the customs of other
countries; speaking a foreign language
fluently is also helpful
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Basic Areas Of Finance
INTERNATIONAL
DOMESTIC
Corporate
Finance
Financial
Institutions
Investments
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Why Study Finance?
• Marketing
– Budgets, marketing research, marketing financial
products
• Accounting
– Dual accounting and finance function, preparation
of financial statements
• Management
– Strategic thinking, job performance, profitability
• Personal finance
– Budgeting, retirement planning, college planning,
day-to-day cash flow issues
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Business Finance
Some important questions that are
answered using finance
– What long-term investments should the firm
take on?
– Where will we get the long-term financing to
pay for the investments?
– How will we manage the everyday financial
activities of the firm?
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Financial Manager
Financial managers try to answer some, or all, of
these questions
The top financial manager within a firm is usually
the Chief Financial Officer (CFO)
– Treasurer – oversees cash management, credit
management, capital expenditures, and financial
planning
– Controller – oversees taxes, cost accounting,
financial accounting, and data processing
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Corporate Organization Chart
Figure 1.1
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Figure 1.2 How the Finance
Area Fits into a Corporation
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Financial Management
Decisions
Capital budgeting
– What long-term investments or projects
should the business take on?
Capital structure
– How should we pay for our assets?
– Should we use debt or equity?
Working capital management
– How do we manage the day-to-day finances
of the firm?
Return to
Quick Quiz
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Forms of Business
Organization
Three major forms in the United States
•Sole proprietorship
•Partnership
– General
– Limited
•Corporation
– S-Corp
– Limited liability company
Return to
Quick Quiz
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Sole Proprietorship
Business owned by one person
Advantages
– Easiest to start
– Least regulated
– Single owner keeps all of
the profits
– Taxed once as personal
income
Disadvantages
– Limited to life of owner
– Equity capital limited to
owner’s personal wealth
– Unlimited liability
– Difficult to sell ownership
interest
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Partnership
Business owned by two or more persons
Advantages
– Two or more owners
– More capital available
– Relatively easy to start
– Income taxed once as
personal income
Disadvantages
– Unlimited liability
• General partnership
• Limited partnership
– Partnership dissolves
when one partner dies or
wishes to sell
– Difficult to transfer
ownership
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Corporation
A legal “person” distinct from owners and a
resident of a state
Advantages
Disadvantages
– Limited liability
– Separation of ownership
and management (agency
– Unlimited life
problem)
– Separation of ownership
– Double taxation (income
and management
taxed at the corporate
– Transfer of ownership is
rate and then dividends
easy
taxed at personal rate,
– Easier to raise capital
while dividends paid are
not tax deductible)
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International Corporate Forms
All of these forms feature public ownership
and limited liability
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Goal of Financial Management
What should be the goal of a corporation?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value per share of
the company’s existing stock
– Maximize the market value of the
existing owners’ equity
Return to
Quick Quiz
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Goal of Financial Management
Does this mean we should do anything
and everything to maximize owner
wealth?
– Outsourcing?
– Off-shoring?
– Enron?
– Corporate support of charities?
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Coca-Cola’s Vision Statement
To achieve sustainable growth, we have
established a vision with clear goals for:
ØProfit
ØPeople
ØPortfolio
ØPartners
ØPlanet
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Corporate Mission
While managers have to cater to all the
stakeholders (such as consumers, employees,
suppliers etc.), they need to pay particular
attention to the shareholders.
If managers fail to pursue shareholder wealth
maximization, they will lose the support of
investors and lenders. The business may cease
to exist and ultimately, the managers will lose
their jobs!
1-24
Ethics in Finance
What do we mean by Ethics?
Give examples of recent financial scandals and
discuss what went wrong from an ethical
perspective.
Scandal is an action or event that causes a public
feeling of shock & strong moral disapproval. For
example Enron’s case
Ethic is a system of accepted rules about behavior,
based on what is considered right and wrong.
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Sarbanes-Oxley Act (SOX)
SOX Act was passed in 2002 “to protect
investors by improving the accuracy and
reliability of corporate disclosures made
pursuant to the securities laws, and for
other purposes”.
SOX Act mandates senior executives to take
responsibility for the accuracy and
completeness of financial reports.
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Sarbanes-Oxley Act
(SarBox, 2002)
Driven by corporate scandals
– Enron, Tyco, WorldCom, Adelphia
Intended to strengthen protection
against accounting fraud and financial
malpractice.
Compliance very costly
– Firms driven to:
• Go public outside the U.S.
• Go private (“go dark”)
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The Agency Problem
Agency relationship
– Principal hires an agent to represent its
interests
– Stockholders (principals) hire managers
(agents) to run the company
Agency problem
– Conflict of interest between principal and
agent
Management goals and agency costs
Return to
Quick Quiz
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Do Managers Act in the
Shareholders’ Interests?
Managerial compensation
– Incentives can be used to align management
and stockholder interests
– Incentives need to be carefully structured to
insure that they achieve their goal
Corporate control
– Threat of a takeover may result in better
management
Other stakeholders
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Example: Work the Web
The Internet provides a wealth of
information about individual companies
• “finance.yahoo.com” is an excellent
site
Example:
–
–
–
–
Southwest Airlines (LUV)
Harley- Davidson (HOG)
Starwood Hotels & Resorts (HOT)
American Express (AXP)
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Cash Flows Between the Firm and the
Financial Markets
Figure 1.2
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Financial Markets
Cash flows to the firm
Primary vs. secondary markets
– Dealer vs. auction markets
– Listed vs. over-the-counter securities
• NYSE
• NASDAQ
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1.6 THE FIVE BASIC PRINCIPLES OF
FINANCE
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PRINCIPLE 1:
Money Has a Time Value
A dollar received today is worth more than a
dollar received in the future.
We can invest the dollar received today to earn
interest. Thus, in the future, you will have more
than one dollar, as you will receive the interest
on your investment.
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PRINCIPLE 2:
There is a Risk-Return Trade-off
We won’t take on additional risk unless we
expect to be compensated with additional return.
Higher the risk, higher will be the expected
return. Note expected return may not be equal
to the realized rate of return.
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Figure 1.3
There Is a Risk-Return Tradeoff
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PRINCIPLE 3:
Cash Flows Are the Source of Value
Profit is an accounting concept and measures a
business’s performance. Cash flow is the amount
of cash that can actually be taken out of the
business.
It is possible for a firm to report profits but have
no cash.
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Incremental Cash Flow
Financial decisions in a firm should consider
“incremental cash flow” i.e. the difference
between the cash flows the company will
produce with the potential new investment
and what it would make without the
investment.
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PRINCIPLE 4:
Market Prices Reflect Information
Investors react quickly to news/information and
decisions made by managers.
Good News ==> Higher stock prices
Bad News ==> Lower stock price.
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PRINCIPLE 5:
Individuals Respond to Incentives
Managers (as agents) respond to incentives they
are given in the workplace. If their incentives are
not properly aligned with those of the firm’s
stockholders (the principal) they may not make
decisions that are consistent with increasing
shareholder value leading to agency costs.
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PRINCIPLE 5:
Individuals Respond to Incentives
(cont.)
The agency problems/costs can be mitigated through:
1. Compensation plans that reward managers when they act to
maximize shareholder wealth.
2. Monitoring by the board of directors
3. Monitoring by financial markets (such as auditors, bankers,
security analysts, credit agencies)
4. The underperforming firms seeing their stock prices fall and
face threat of being taken over and have their management
teams replaced.
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Cash Flow-Production Cycle
Changes in equity; changes in debt; taxes paid; dividends paid
Investment
Cash
Collection of
credit sales
purchase
Fixed
assets
Cash
sales
Depreciation
A/C
Receivable
Credit sales
Inventory
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IFRS
International Financial Reporting Standards
(IFRS) are a set of accounting rules for the
financial statements of public companies that
are intended to make them consistent,
transparent, and easily comparable around the
world.
The IFRS are issued by the International
Accounting Standards Board (IASB).
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Statement of Financial Position
This is formerly known as the balance sheet.
IFRS influences the ways in which the
components of a balance sheet are reported.
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Statement of Comprehensive
Income
This can take the form of one statement or
be separated into a profit and loss
statement and a statement of other
income, including property and equipment.
It is formerly known as Profit and Loss
Account
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1-46
Statement of Changes in Equity
Also known as a statement of retained
earnings, this documents the company's
change in earnings or profit for the given
financial period.
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Statement of Cash Flows
This report summarizes the company's
financial transactions in the given period,
separating cash flow into operations,
investing, and financing.
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In addition to these basic reports
• In addition to these basic reports, a company
must give a summary of its accounting
policies.
• The full report is often seen side by side
with the previous report to show the
changes in profit and loss.
• Chinese companies do not use IFRS or GAAP.
They use Chinese Accounting Standards for
Business Enterprises (ASBEs).
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Quick Quiz
• What are the four basic areas of finance? (Slide
1.4)
• What are the three types of financial
management decisions, and what questions are
they designed to answer? (Slide 1.13)
• What are the three major forms of business
organization? (Slide 1.14)
• What is the goal of financial management?
(Slide 1.19)
• What are agency problems, and why do they
exist within a corporation? (Slide 1.22)
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Key Terms
•
•
•
•
•
•
•
Agency problem
Capital budgeting
Capital structure
Corporation
Debt
Dividends
Equity
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Key Terms (cont.)
•
•
•
•
•
•
•
Financial markets
General partner
General partnership
Limited liability company (LLC)
Limited partner
Limited partnership
Opportunity cost
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Key Terms (cont.)
•
•
•
•
•
•
•
•
Partnership
Shareholders
Shares
Sole proprietorship
Stockholders
Working capital management
ETF – Exchange-Traded Funds
Distribution vs. Dividend.
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Home works #1
• Explain what is the difference between
dividends and distributions?
• What is Exchange-Traded Funds (ETF) ?
• What is IAS and IFRS？
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Chapter 1
END
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