Introduction
•
•
•
•
Organizing a Business
The Role of The Financial Manager
Financial Markets
Corporate Goals & Incentives
Organizing a Business
• Types of Business Organizations
–
–
–
–
Sole Proprietorships
Partnerships
Corporations
Hybrids
•
•
•
•
Limited Partnerships
LLP
LLC
PC
Organizing a Business
Sole
Proprietorship
Partnership
Corporation
Who owns the
business?
The Manager
Partners
Shareholders
Are managers
and owners
separate?
What is the
owner’s
liability?
Are owners &
the business
taxed
separately?
No
No
Usually
Unlimited
Unlimited
(exceptions)
Limited
No
No
Yes
The Role of The Financial Manager
(2)
(1)
Financial
managers
Firm's
operations
(4a)
(4b)
(3)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
Financial
markets
Financial Markets
Company
Banks
Insurance Cos.
Obligations
Funds
Intermediary
Brokerage Firms
Obligations
Funds
Depositors
Policyholders
Investors
Investor
The Role of The Financial Manager
• Investment Decisions
– “Capital Budgeting”
– Buy real assets that are worth more than they
cost
• Financing Decisions
—Source of Funds “Capital Markets”
—Capital Structure
Advantages of Intermediation
1 – Transaction costs/Payments mechanisms.
2 – Matching borrowers and lenders
• Borrower may want to borrow for 2
years
• May have many lenders that want to
lend for a year each.
3 – Pooling of Risk
Goals of The Corporation
• Shareholders desire wealth
maximization
• Do managers maximize shareholder
wealth?
• Managers have many constituencies
“stakeholders”
• “Agency Problems” represent the
conflict of interest between
management and owners
Goals of The Corporation
Agency Problem “Solutions”
1 - Compensation plans
2 - Board of Directors
3 - Takeovers
4 - Specialist Monitoring
5 – Auditors
Remark: Problems can still occur because of
differences of information.
Financial Accounting
•
•
•
•
•
The Balance Sheet
The Income Statement
The Statement of Cash Flows
Accounting for Differences
Taxes
The Balance Sheet
Definition
Financial statements that show
the value of the firm’s assets and
liabilities at a particular point in
time (from an accounting
perspective).
The Balance Sheet
The Main Balance Sheet Items
Current Assets
Cash & Securities
Receivables
Inventories
+
Fixed Assets
Tangible Assets
Intangible Assets

The Balance Sheet
The Main Balance Sheet Items
Current Liabilities
Payables
Short-term Debt
Current Assets
Cash & Securities
Receivables
Inventories
+
Fixed Assets
Tangible Assets
Intangible Assets
=
+
Long-term Liabilities
+
Shareholders’ Equity
Market Value vs. Book Value
Book Values are determined by GAAP
Market Values are determined by current
values
Equity and Asset “Market Values” are usually
higher than their “Book Values”
Market Value vs. Book Value
Example
According to GAAP, your firm has equity worth $6
billion, debt worth $4 billion, assets worth $10
billion. The market values your firm’s 100 million
shares at $75 per share and the debt at $4 billion.
Q: What is the market value of your assets?
Market Value vs. Book Value
Example
According to GAAP, your firm has equity worth $6
billion, debt worth $4 billion, assets worth $10
billion. The market values your firm’s 100 million
shares at $75 per share and the debt at $4 billion.
Q: What is the market value of your assets?
A: Since (Assets=Liabilities + Equity), your
assets must have a market value of $11.5 billion.
Market Value vs. Book Value
Example (continued)
Book Value Balance Sheet
Assets = $10 bil
Debt = $4 bil
Equity = $6 bil
Market Value vs. Book Value
Example (continued)
Book Value Balance Sheet
Assets = $10 bil
Debt = $4 bil
Equity = $6 bil
Market Value Balance Sheet
Assets = $11.5 bil
Debt = $4 bil
Equity = $7.5 bil
The Income Statement
Definition
Financial statement that shows
the revenues, expenses, and net
income of a firm over a period of
time (from an accounting
perspective).
The Income Statement
Earnings Before Interest & Taxes (EBIT)
EBIT = total revenues
minus costs
minus depreciation
The Income Statement
Pepsico Income Statement (year end 1998)
Net Sales
COGS
Other Expenses
Selling, G&A expenses
Depreciation expense
EBIT
Net interest expense
Taxable Income
Income Taxes
Net Income
22,348
9,330
291
8,912
1,234
2,581
321
2,260
270
1,990
Profits vs. Cash Flows
Differences
• “Profits” subtract depreciation (a non-cash
expense)
• “Profits” ignore cash expenditures on new
capital (the expense is capitalized)
• “Profits” record income and expenses at the
time of sales, not when the cash exchanges
actually occur
• “Profits” do not consider changes in working
capital
The Statement of Cash Flows
Pepsico Statement of Cash Flows (excerpt - year end 1998)
Net Income
1,990
The Statement of Cash Flows
Pepsico Statement of Cash Flows (excerpt - year end 1998)
Net Income
Non-cash expenses
Depreciation
Other
Changes in working capital
A/R=(303) A/P=253 Inv=(284) other=(47)
Cash Flow from Operations
1,990
1,234
382
(381)
3,212
The Statement of Cash Flows
Pepsico Statement of Cash Flows (excerpt - year end 1998)
Net Income
Non-cash expenses
Depreciation
Other
Changes in working capital
A/R=(303) A/P=253 Inv=(284) other=(47)
Cash Flow from Operations
Cash Flow for New Investments
Cash Raised by New Financing
Net Change in Cash Position
1,990
1,234
382
(381)
3,212
(5,019)
190
(1,617)
Taxes
• Taxes have a major impact on financial
decisions
Marginal Tax Rate is the tax that the
individual pays on each extra dollar of
income.
Average Tax Rate is the total tax bill divided
by total income.
Taxes
Example - Taxes and Cash Flows can be changed by
the use of debt. Firm A pays part of its profits as
debt interest. Firm B does not.
Taxes
Example - Taxes and Cash Flows can be changed by
the use of debt. Firm A pays part of its profits as
debt interest. Firm B does not.
EBIT
Interest
Pretax Income
Taxes (35%)
Net Income
Firm A
100
40
60
21
39
Taxes
Example - Taxes and Cash Flows can be changed by
the use of debt. Firm A pays part of its profits as
debt interest. Firm B does not.
EBIT
Interest
Pretax Income
Taxes (35%)
Net Income
Firm A
100
40
60
21
39
Firm B
100
0
100
35
65
Taxes
FOOD FOR THOUGHT - If you were both the debt
and equity holders of the firm, which would generate
more cash flow to you? (assume Net Income = Cash
Flow)
Firm A
Firm B
Net Income
39
65
+ Interest
40
0
Net Cash Flow
79
65
Why the difference?
Net Income
+ Interest
Net Cash Flow
Firm A
39
40
79
Firm B
65
0
65
• Interest is not taxed!
• 40*0.35=14 (which is the difference)