Thursday morning
Finance
What is Finance?
• Finance -- The function in a business that acquires
funds for a firm and manages them within the firm.
• Finance activities include:
- Preparing budgets
- Creating cash flow analyses
- Planning for expenditures
Financial Management
• Financial Management -- The job of
managing a firm’s resources to meet its
goals and objectives.
What Financial Managers Do
Why Do Firms Fail Financially?
• Undercapitalization
• Poor control over cash flow
• Inadequate expense control
Who’s Who in Finance
• CFO -- Chief Financial Officer
• CFP -- Certified Financial Planner
• CFA -- Chartered Financial Analyst
• Controller -- Chief Accounting Officer
Financial Forecasting
• Short-Term Forecast -- Predicts revenues, costs
and expenses for a period of one year or less.
• Cash-Flow Forecast -- Predicts the cash inflows
and outflows in future periods, usually months or
quarters.
• Long-Term Forecast -- Predicts revenues, costs,
and expenses for a period longer than one year
and sometimes as long as five or ten years.
Budgeting
• Budget -- Sets forth management’s expectations
for revenues and allocates the use of specific
resources throughout the firm.
• Budgets depend heavily on the balance sheet,
income statement, statement of cash flows and
short-term and long-term financial forecasts.
• The budget is the guide for financial operations
and expected financial needs.
Types of Budgets
• Capital Budget -- Highlights a firm’s
spending plans for major asset purchases
that often require large sums of money.
• Cash Budget -- Estimates cash inflows and
outflows during a particular period like a
month or quarter.
• Operating (Master) Budget -- Ties together
all the firm’s other budgets and summarizes
its proposed financial activities.
Capital Budgeting Example
Investment in equipment
Working capital needed
Annual net cash inflows
Relining of equipment
Salvage value of equip.
Working capital released
Net present value
Years
Now
Now
1-5
3
5
5
Cash
Flows
$ (160,000)
(100,000)
80,000
(30,000)
5,000
100,000
10%
Factor
1.000
1.000
3.791
0.751
0.621
0.621
Present
Value
$ (160,000)
(100,000)
303,280
(22,530)
3,105
62,100
$ 85,955
The Master Budget: An Overview
Sales budget
Ending inventory
budget
Direct materials
budget
Production budget
Direct labor
budget
Selling and
administrative
budget
Manufacturing
overhead budget
Cash Budget
Budgeted
income
statement
Budgeted
balance sheet
The Cash Budget
Establishing Financial Control
• Financial Control -- A process in which a
firm periodically compares its actual
revenues, costs and expenses with its
budget.
FACTORS USED in ASSESSING
FINANCIAL CONTROL
• Is the firm meeting its short-term financial
commitments? (current ratio/quick ratio)
• Is the firm producing adequate operating profits on
its assets? (ROA)
• How is the firm financing its assets? (debt or
equity)
• Are the firms owners receiving an acceptable
return on their investment? (ROE/ROI)
WAYS to RAISE
START-UP CAPITAL
• Seek out a microloan from a microlender
• Use asset-based lending or factoring
• Turn to the web and seek out peer-to-peer
lending
• Research local banks
• Sweet-talk vendors you want to do
business with
Sources of Capital
• Personal savings
• Relatives
• Former employers
• Banks & finance companies
• Government agencies
• Venture capitalists -- Individuals or companies that invest in
new businesses in exchange for partial ownership. (generally
pooled funds professionally managed)
• Angel investors – use their own funds
• Super Angels
HOW SMALL BUSINESSES
CAN IMPROVE CASH FLOW
• Be more aggressive in collecting accounts
receivable.
• Offer customers discounts by paying early.
• Take advantage of special payment terms
from vendors.
• Raise prices.
• Use credit cards discriminately.
ALTERNATIVE
SOURCES of FUNDS
• Debt Financing -- The funds raised
through various forms of borrowing that
must be repaid.
• Equity Financing -- The funds raised
from within the firm from operations or
through the sale of ownership in the firm
(such as stock).
SHORT and LONG-TERM
FINANCING
• Short-Term Financing -- Funds needed
for a year or less.
• Long-Term Financing -- Funds needed
for more than a year.
Why Firms Need Financing
Short-Term Funds
Long-Term Funds
Monthly expenses
New-product development
Unanticipated emergencies
Replacement of capital equipment
Cash flow problems
Mergers or acquisitions
Expansion of current inventory
Expansion into new markets
Temporary promotional programs
New facilities
TYPES of
SHORT-TERM FINANCING
• Trade Credit -- The practice of buying goods or services
now and paying for them later.
• Businesses often get terms 2/10 net 30 when
receiving trade credit.
• What is this really worth??
• Promissory Note -- A written contract agreeing to pay a
supplier a specific sum of money at a definite time.
DIFFERENT FORMS of
SHORT-TERM LOANS
• Commercial banks offer short-term loans like:
- Secured Loans -- Backed by collateral.
- Unsecured Loans -- Don’t require collateral from the
borrower.
- Line of Credit -- A given amount of money the bank
will provide so long as the funds are available.
- Lehman Brothers (repo market)
- New York Times video – Hartsko
- Grameen Bank
Factoring Your Accounts Receivable
• Selling your AR for cash
• Factor is an intermediary that buys a company’s
AR, at a discount; and then collects the proceeds
• Amount of discount is based on age of
receivables, strength of business
• Can be an expensive form of short-term financing
Commercial Paper
• Commercial Paper -- Unsecured promissory
notes in amounts of $100,000+ that come
due in 270 days or less.
• Since commercial paper is unsecured, only
financially stable firms are able to sell it.
• Assists in financing of current assets and
payment of current liabilities; cannot be used
on long-term assets
SETTING LONG-TERM
FINANCING OBJECTIVES
• Three questions of financial managers in setting longterm financing objectives:
1. What are the organization’s long-term goals and
objectives?
2. What funds do we need to achieve the firm’s long-term
goals and objectives?
3. What sources of long-term funding (capital) are available,
and which will best fit our needs?
USING LONG-TERM
DEBT FINANCING
• Long-term financing loans generally come due
within 3 -7 years but may extend to 15 or 20 years.
• Term-Loan Agreement -- A promissory note that
requires the borrower to repay the loan with
interest in specified monthly or annual
installments.
• A major advantage of debt financing is the interest
the firm pays is tax deductible.
USING DEBT FINANCING
by ISSUING BONDS
• Indenture Terms -- The terms of
agreement in a bond issue.
• Secured Bond -- A bond issued with
some form of collateral (i.e. real estate).
• Unsecured (Debenture) Bond -- A bond
backed only by the reputation of the
issuing company.
Securing Equity Financing
• A company can secure equity financing by:
- Selling shares of stock in the company.
- Earning profits and using the retained earnings as
reinvestments in the firm.
- Attracting Venture Capital -- Money that is invested in
new or emerging companies that some investors believe
have great profit potential.
USING LEVERAGE for
FUNDING NEEDS
• Leverage -- Raising funds through borrowing
to increase the firm’s rate of return.
• Cost of Capital -- The rate of return a
company must earn in order to meet the
demands of its lenders and expectations of
equity holders.
• ROA vs ROE Excel example
Securities Markets
• Securities markets are financial marketplaces for
stocks and bonds and serve two primary functions:
1. Assist businesses in finding long-term funding to finance
capital needs.
2. Provide private investors a place to buy and sell
securities such as stocks and bonds.
TYPES of SECURITIES
MARKETS
• Securities markets are divided into primary and
secondary markets:
- Primary markets handle the sale of new securities.
- Secondary markets handle the trading of securities
between investors with the proceeds of the sale going to
the seller.
• Initial Public Offering (IPO) -- The first offering
of a company’s stock. LinkedIn
INVESTMENT BANKERS
and INSTITUTIONAL INVESTORS
• Investment Bankers -- Specialists who
assist in the issue and sale of new
securities. Goldman Sachs
• Institutional
Investors
-Large
organizations such as pension funds or
mutual funds that invest their own funds or
the funds of others. Vanguard, CALPERS
Stock Exchanges
• Stock Exchange -- An organization whose
members can buy and sell securities on behalf of
companies and individual investors.
• Over-the-Counter (OTC) Market -- Provides
companies and investors with a means to trade
stocks not listed on the national securities
exchanges.
• NASDAQ -- A telecommunications network that
links dealers across the nation so they can
exchange securities.
The SEC
• Securities and Exchange Commission
(SEC) -- The federal agency responsible for
regulating the various stock exchanges;
created in 1934 through the Securities and
Exchange Act.
• Prospectus -- A detailed registration
statement that includes extensive economic
and financial information that must be sent to
prospective investors.
The Language of Stocks
• Stocks -- Shares of ownership in a company.
• Stock Certificate -- Evidence of stock
ownership.
Apple
• Dividends -- Part of a firm’s profits that the
firm may distribute to stockholders as either
cash or additional shares.
Advantages of Issuing Stocks
• Stockholders are owners of a firm and
never have to be repaid their investment.
• There’s no legal obligation to pay
dividends.
• Issuing stock can improve a firm’s balance
sheet since stock creates no debt.
Disadvantages of Issuing Stocks
• Stockholders have the right to vote for a
company’s board of directors.
• Issuing new shares of stock can alter the control of
the firm.
• Dividends are paid from after-tax profits and are
not tax deductible. (double taxation)
• The need to keep stockholders happy can affect
management’s decisions.
Two Classes of Stock
• Common Stock -- The most basic form; holders
have the right to vote for the board of directors and
share in the profits if dividends are approved.
• Preferred Stock -- Owners are given preference in
the payment of company dividends before common
stock dividends are distributed. Preferred stock can
also be:
- Callable
- Convertible
- Cumulative
Key Stock Market Indicators
• Dow Jones Industrial Average -- The
average cost of 30 selected industrial stocks.
• Critics say the 30-company Dow is too small
a sample and suggest following the S&P 500.
• S&P 500 tracks the performance of 400
industrial, 40 financial, 40 public utility, and
20 transportation stocks.
Stock Splits
• Stock Splits -- An action by a company that gives
stockholders two or more shares of additional
stock for every share that’s outstanding.
• Splits cause no change in the firm’s ownership
structure and no change in the investment’s value.
• Firms can never be forced to spilt their stocks.
• Berkshire Hathaway
UNDERSTANDING STOCK
QUOTATIONS
Learning the Language of Bonds
• Bond -- A corporate certificate indicating
that an investor has lent money to a firm.
• The principal is the face value of the bond.
• Interest -- The payment the bond issuer
makes to the bondholders to compensate
them for the use of their money.
• Understanding Bond Quotes
Advantages of Issuing Bonds
• Bondholders are creditors, not owners of the firm and can’t
vote on corporate matters.
• Bond interest is tax deductible.
• Bonds are a temporary source of funding and are eventually
repaid.
• Bonds can be repaid before the maturity date if they contain a
call provision.
• Google, 2
Disadvantages of Issuing Bonds
• Bonds increase debt and can affect the
market’s perception of the firm.
• Paying interest on bonds is a legal obligation.
• If interest isn’t paid, bondholders can take
legal action.
• The face value of the bond must be repaid on
the maturity date.
Bond Ratings
Rating
Moody’s
Standard & Poor’s
Description
Aaa
AAA
Highest Quality
Aa
AA
High Quality
A
A
Upper-Medium Grade
Baa
BBB
Medium Grade
Ba
BB
Lower-Medium Grade
B
B
Speculative
Caa
CCC, CC
Poor
Ca
C
Highly Speculative
C
D
Lowest Grade
DIFFERENT CLASSES of
CORPORATE BONDS
• Unsecured bonds (debenture bonds): not
backed by specific collateral.
• Secured bonds: backed by collateral (land or
equipment).
DIFFERENCES BETWEEN DEBT
and EQUITY FINANCING
Types of Financing
Conditions
Debt
Equity
Management
influence
None. Unless special
conditions have been
agreed on.
Common stock
holders have voting
rights.
Repayment
Debt has a maturity
date.
Stock has no maturity
date.
Yearly obligations
Payment of interest.
The firm isn’t legally
liable to pay
dividends.
Tax benefits
Interest is tax
deductible.
Dividends are not tax
deductible.
Investing in Mutual Funds
• Mutual Fund -- An organization the buys
stocks and bonds and then sells shares in
those securities to the public. The fund
pools investors’ money and buys stocks
according to the fund’s purpose.
• Enables investors to diversify their
risks
Comparing Investments
AVERAGE ANNUAL RETURN of
ASSET CLASSES (1926-2007)
Investment
Return
Small company stocks
12.2%
Large company stocks
9.5%
Corporate bonds
6.0%
Long-term government bonds
5.8%
Treasury bills
4.1%
HOW to be a MILLIONAIRE
should be HOW TO BE HAPPY!!
•
Self-employed people are 5 times more likely to be millionaires.
•
Millionaires studied tended to have modest homes and bought used
cars.
•
Millionaires are educated, work hard, save money and make purchases
carefully.
•
•
The Automatic Millionaire
•
The Millionaire Next Door – seven rules
Excel spreadsheet
FINANCIAL PLANNING BEGINS
with MAKING MONEY
• An investment in education pays the best interest
rate:
- A typical full-time worker with a four-year degree earns
about $50,000, 62% more than a person with a high
school diploma.
- The lifetime earnings of a family with bachelor’s degrees
will be about $1.6 million more than a family with high
school diplomas.
Six Steps to Control Your Finances
1. Take an inventory of your financial assets
2. Keep track of all your expenses
3. Prepare a budget
4. Pay off your debts
5. Start a savings plan
6. Borrow only to buy assets that increase in value.
BUILDING YOUR
FINANCIAL BASE
• Live frugally. If married, try to live on one income.
• Your first major investment should be a low-priced
home – yes vs no
• Buy for the long term and don’t live beyond your
means.
• Contrarian advice??
Financial Benefits of Buying a Home
• A home is an investment you can live in.
• Paying for a home is a good way of forcing
yourself to save.
• Interest paid on your home loan is tax deductible.
• Three keys to optimal return on your home are:
location, location, location.
• Spreadsheet on mortgage
Life Insurance
• Term Insurance -- A pure insurance protection for a given
number of years that typically costs less the younger you buy it.
Get a quote
• Permanent Life Insurance -- Combines pure insurance with
savings, so you buy both insurance and a savings plan.
• Whole, universal
• Variable Life Insurance -- A form of whole life insurance
that invests the cash value of the policy in stocks or other
high-yielding securities.
Retirement Planning
• Kiplinger – 5 best ways to save for retirement
and 5 things to know about IRAs
• Social Security -- The Old-Age, Survivors, and Disability
Insurance Program established by the Social Security Act
of 1933.
• Social Security benefits are paid through social
security taxes paid by workers currently earning
wages in the market.
• The Social Security fund is expected to be hard
pressed because of the growing number of older
adults.
IRAs
• Individual Retirement Accounts (IRAs) -- Taxdeferred investment plans that enable a person to
save part of their income for retirement.
• Tax-Deferred Contributions -- Contributions in
which you pay no current taxes, but earnings gained in
the IRA are taxed as income after withdrawal.
• Roth IRA -- Doesn’t give an up-front tax deduction
but earnings grow tax-free and are tax-free when they
are withdrawn.
401(k) Plans
• 401(k) Plan -- An employer-sponsored savings plan that
allows you to deposit a set amount of pretax dollars and
collect compounded earnings tax-free until withdrawal.
• Three benefits of 401(k) plans:
1.
Contributions reduce your present taxable income
2.
Tax is deferred on the earnings
3.
Many employers will match your contributions.
1.
VU – we put in 5%, they match 10%!!
Time Value of Money
•
•
•
•
Future Value of a Lump Sum
Future Value of an Annuity
Present Value of a Lump Sum
Present Value of an Annuity