by
William R. Lasher
Nichols College
PowerPoint Presentation Slides by
Western Washington University
© 2003 South-Western/Thomson Learning

© 2003 South-Western/Thomson Learning
Chapter 1

 Investments and financial markets
 Financial management of corporations
 Fields are separate but related
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Real asset —an object that provides a service, such as a house, car, art, coin…
Financial asset —a document representing a claim to income
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Stock —ownership interest in a company
• Entitled to a share of the firm’s profits, either dividends or future growth
Bond —debt interest in a company
• Entitled to interest and repayment of principal
Investing involves buying financial assets in the hope of earning a return
 Can be made directly or indirectly (buying shares in a mutual fund)
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 Financial Market
 Financial assets are issued by corporations and bought by investors in financial markets
• A framework or organization in which people can buy/sell securities
• Stock market (NYSE, AMEX, OTC)--entire network of brokers and exchanges all connected together
• Stockbroker (broker)--person who is licensed to trade securities for a commission
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Secondary market —place where investors trade securities among themselves (NYSE, etc .)
 Most transactions are of this type
Primary market —market where securities are initially sold (I.P.O.)
 Investments
 Making decisions about buying and selling stock and bonds
 Financial management
 Decisions about raising money and how to spend it
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 Financing means raising money to acquire something
 Forms of Financing
 Issuing stock (equity financing)
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Borrowing money (debt financing)
• Bank
• Issuing bonds
• Leasing
Internal financing (retaining earnings)
• Still considered equity financing
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 Field of finance includes raising money and investing money
 Changing Focus of Finance
 Finance used to be narrowly limited to financial market activity
 However has expanded to include
• Portfolio formation and analysis
• A portfolio is a collection of securities
• Financial management within an organization
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 Financial Management is the management and control of money and money-related operations within a business
 Executive in charge of finance department
 CFO: Chief Financial Officer (AKA: VP of Finance)
• Typically reports directly to the President of the corporation
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 Refers to the functions of the finance department
 Keeping records
 Receiving payments from customers
 Making payments to suppliers
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Borrowing funds
Purchasing assets
Selling stock
Paying dividends, etc .
Accounting department is included in the broad definition of finance.
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 Business Decisions
 Finance department is in charge of:
• Determining which assets a firm should purchase
• Acquiring another firm
• Expanding operations
• A different product line
• Current operations expanding to another country
• Deciding how those assets will be financed
• Equity
• Debt
• Loan via bank
• Bond issue
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 Oversight
 Finance department must also perform an oversight function
• Looking over everyone’s shoulder to make certain money is being used effectively
• For example,
• Are manufacturing costs too high?
• Are advertising costs too high?
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 Investors buy securities for the future cash flows expected from them
 Price investors are willing to pay depends on expectations of how well the companies are likely to do
 Link between company management and investors comes from this relationship between price and expected financial results
 Everything firm does is evaluated by market and
‘graded’ by either an  ,  , or no change in security price
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Does management care what ‘grade’ it receives?
 YES! Why?
• Management will need to issue new securities in the future (to raise $) and therefore want a high security price
• Stockholders own the firm and if the stock price declines shareholders will be disgruntled
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 Accounting: a system of record-keeping designed to portray a firm’s operations in a fair/unbiased manner
 Generate financial statements which are provided to the marketplace
 Finance: a process of decision-making related to raising money, analyzing results, etc.
 Use the output generated by accountants as inputs in finance
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 Finance department generally consists of both the accounting department and the treasury department
 Controller is in charge of the accounting department
 Treasury department deals with finance activities
 Crossover is possible
 Usually easier for an accountant to move to the treasury department
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Accounting attempts to reflect a firm’s financial results in a way that represents what is physically occurring
 Finance is interested in how cash is flowing (or expected to flow)
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We need a cash amount because we’ll be looking at returns on money invested, and you can’t invest a non-cash number
• Cash is King
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 Accounting is the language of finance
 Thus all finance professionals need some accounting knowledge
• Level of accounting knowledge needed depends on job
• Financial analyst needs to know LOTS of accounting because s/he investigates companies and makes recommendations concerning their value in market (must decipher complex financial statements as part of that process)
• Stockbrokers do not need as thorough an understanding because they generally trade securities based on the financial analyst’s recommendation
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 Financial theory developed from economics
 Modern financial theory began as a branch of economics in the 1950s
• Today finance is viewed as a separate field
 Scholars in both fields make observations between business world and government and attempt to model the behavior
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Businesses can be legally or organized as
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A sole proprietorship
A partnership
A corporation
Legal organization has an impact on
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Raising money
Taxation
Financial liability
Issues really only important regarding small businesses
 Virtually all large corporations are organized as C-type organizations
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Getting started
 Easy to do
Taxes
 Profit is taxed as personal income to the business owner
• Are taxed only once
• Taxed at personal income tax rates
Raising money
 If entrepreneur decides to go outside the firm to raise money, s/he can obtain a loan
• Lending money is risky
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Best possible outcome: repayment of principal and interest
• Worst possible outcome: lose everything
• Thus, most lenders require collateral
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Many entrepreneurs use their house as collateral
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 Getting started
 Requires a legal incorporation process
• Takes time, work and money
 Taxes
 When business makes a profit taxes are paid twice
• The corporation pays a tax at the corporate tax rate
• Dividends paid to individuals are taxed at an individual’s personal tax rate
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 Raising Money
 Money for a corporation can be raised by
• Borrowing
• A corporation faces the same issues as a sole proprietorship when raising money
• Offering stock to investors
• If less than a 50% interest is sold, original owner still maintains effective control
• Owning stock is risky
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• Best possible outcome: may get rich
Worst possible outcome: may lose all of your investment
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 Limited liability states that a stockholder is not liable for a corporation’s debts
 Implies that the most stockholder can lose is 100% of his investment in the stock
 In a sole proprietorship, the business owner stands to lose his personal property if all the assets of the business are insufficient to cover all liabilities
 Personal guarantees make entrepreneurs liable for loans made to their business
• Destroys the value of limited liability
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 Major financial advantage of corporate form
 Ability to raise money by issuing stock
 Major financial disadvantage
 Double taxation of earnings
 Government encourages formation of small businesses because they create numerous jobs
 Government allows creation of S-type corporation
• Lets small businesses avoid double taxation
• Offers limited liability
• Offers ability to sell stock to raise money
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Economics —goal is to maximize profit
 But what about R&D?
• If you eliminate R&D you’ll increase short-term profit and hurt long-term profit
Finance —Stockholders own the company so the goal is to maximize their wealth, generally by maximizing the stock price
 This goal bypasses the concern of whether the short-term or long-term is more important, because stock price incorporates both !
• If R&D were eliminated the stock price would not rise, but rather, drop
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 Constituencies of the company who have a vested interest in the way the firm is operated and include
 Stockholders
 Employees
 Customers
 Community
 Management
 Creditors
 Suppliers
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 Example: Employees want management to build an athletic facility on corporate grounds
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Benefit —more effective employees (feel better, happier, therefore more productive)
Cost —will come from profits that belong to stockholders
• This represents a conflict of interest between stockholders and employees
• Something that benefits one group and takes away from another
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Management represents a privileged stakeholder group
The ownership of a widely held company is very dispersed so no one has enough control to influence management
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 IBM has almost 2 billion shares outstanding, and over 600,000 shareholders —so no one person has enough control to influence management
This allows top management to become entrenched in positions controlling large amounts of resources
Management is able to use these resources for their own benefit
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 Management (agent) is controlling resources owned by stockholders (principal) and may not make the decisions stockholders want
 The Abuse of Agency
 Privileges and luxuries provided to executives are called perquisites or ‘perks’
• Example —management compensation
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Management receives exorbitant salaries/bonuses ($50+ million) while the company performance is poor
• Additional perks include boats, airplanes, country club memberships, etc .
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 Controlling the agency problem
 Efforts to manage agency problem include
• Monitor management (audits)
• Tie management bonuses to corporate stock performance via a stock option or to corporate profit
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 A creditor is anyone owed money by a business including lenders, vendors, employees, or the government
 Actions taken by the leveraged company that are riskier than before they borrowed money place creditors at risk
 Lenders generally put clauses in loan agreements to prevent this from occurring
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