Introduction • Organizing a Business • The Role of The Financial Manager • Financial Markets • Corporate Goals & Incentives
Dec 21, 2015
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
SoleProprietorship
Partnership Corporation
Who owns thebusiness?
The Manager Partners Shareholders
Are managersand ownersseparate?
No No Usually
What is theowner’sliability?
Unlimited Unlimited(exceptions)
Limited
Are owners &the businesstaxedseparately?
No No Yes
Organizing a Business
Financial
managersFirm's
operations
Financial
markets
(1) Cash raised from investors
(1)
(2) Cash invested in firm
(2)
(3) Cash generated by operations
(3)
(4a) Cash reinvested
(4a)
(4b) Cash returned to investors
(4b)
The Role of The Financial Manager
Financial Markets
Funds
Funds
Banks
Insurance Cos.
Brokerage Firms
Obligations
Depositors
Policyholders
Investors
Obligations
Company
Intermediary
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 AssetsCash & SecuritiesReceivablesInventories
+
Fixed AssetsTangible AssetsIntangible Assets
The Balance Sheet
The Main Balance Sheet Items
Current AssetsCash & SecuritiesReceivablesInventories
+
Fixed AssetsTangible AssetsIntangible Assets
Current LiabilitiesPayablesShort-term Debt
+
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 StatementPepsico Income Statement (year end 1998)
Net Sales 22,348
COGS 9,330
Other Expenses 291
Selling, G&A expenses 8,912
Depreciation expense 1,234
EBIT 2,581
Net interest expense 321
Taxable Income 2,260
Income Taxes 270
Net Income 1,990
Profits vs. Cash FlowsDifferences
• “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 FlowsPepsico Statement of Cash Flows (excerpt - year end 1998)
Net Income 1,990
The Statement of Cash FlowsPepsico Statement of Cash Flows (excerpt - year end 1998)
Net Income 1,990
Non-cash expenses
Depreciation 1,234
Other 382
Changes in working capital
A/R=(303) A/P=253 Inv=(284) other=(47) (381)
Cash Flow from Operations 3,212
The Statement of Cash FlowsPepsico Statement of Cash Flows (excerpt - year end 1998)
Net Income 1,990
Non-cash expenses
Depreciation 1,234
Other 382
Changes in working capital
A/R=(303) A/P=253 Inv=(284) other=(47) (381)
Cash Flow from Operations 3,212
Cash Flow for New Investments (5,019)
Cash Raised by New Financing 190
Net Change in Cash Position (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.
Firm A
EBIT 100
Interest 40
Pretax Income 60
Taxes (35%) 21
Net Income 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.
Firm A Firm B
EBIT 100 100
Interest 40 0
Pretax Income 60 100
Taxes (35%) 21 35
Net Income 39 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?
Firm A Firm B
Net Income 39 65
+ Interest 40 0
Net Cash Flow 79 65
• Interest is not taxed!• 40*0.35=14 (which is the difference)