An Introduction to Finance- Economics: allocation of scarce resources with alternative useso Finance (part of economics): way individuals and businesses raise, allocate, and manage monetary resources Four areas- Corporate Finance (decisions the firm makes)- Investments (Asset Pricing)- Financial Institutions- International Finance Exclusively future oriented Risk and Return are positively related- Who’s who?o Chief Financial Officer (CFO): top manager within firmo Treasurer: oversees cash management, credit management, capital expenditures, and financial planningo Controller: oversees taxes, cost accounting, financial accounting and data processing (normally a CPA)- Capital Structureo How to pay- Capital managemento Day-to-day responsibilities- Forms of Business Organizationso Sole Proprietorship Single owner/Single employee- Ex. Contractor Advantages- Easy to start- Little regulations- Keep all profits- Taxed once as personal income Disadvantages- Limited to life of owner- Equity capital limited to owner’s personal wealth- Unlimited liability (legal issues)- Difficult to sell ownership interestso Partnership General and limited liabilities Examples: Law Firms, Accounting Firms Advantages- Have more than one owner- More capital available- Easy to start (partnership agreement)- Income taxed once as personal incomeo Based on personal income tax rates Disadvantages- Unlimited liability, general partnership and limited partnershipo General: managing partner (unlimited legal liability)o Limited: only lose what you have invested into company- Partnerships dissolve when one partner dies or decides to sell (harder to sell)- Difficult to transfer ownershipo Corporations Advantages- Limited liability (amount you invested in—decreases risks)- Unlimited life (own legal entity)- Separation of ownership and management- Transfer of ownerships is easy (high liquid)- Easier to raise capitalo More stable Disadvantages- Separation of ownership and managemento Can’t oversee day-to-day operations- Double taxation (income taxed at the corporate rate andthen dividends taxed at the personal rate) on corporate profits- Goal of Financial Managemento Maximize stock price Stock values reflect current and future (long-term) interests of the firmo Agency relationships Principal hire an agent to represent his/her interests Stockholders (principal) hire managers (agents) to run company and act on principal’s behalfo Agency problems Conflict in interests between principal and agent- Agent incentive although its not in the principal’s best interest- Managing managerso Managerial compensation (manager pay)o Incentives can be used to align management and stockholder interests(stock for managers incentive)o Incentives needs to be structuredo Corporate control (board of directors)o Threat of takeover may result in better managemento Other stakeholders Since goal is to grow stake wealth- Financial Markers (access of money)o Cash flow to the firmo Primary market: sell bonds and receive money Firms receive benefits (ex. IPO-Sell company shares)o Secondary: all transactions that happen after initial transactions (trade between individuals—doesn’t affect companyChapter 2- Financial Statements availableo Balance Sheet Snapshot of firms assets and liabilities at a given point of time- Assets are listed in order of decreasing liquidityo Liquidity: ease of conversion to cash (how easy to sell something) without loss in value Formula (Balance Sheet Identity) - Total Assets= Total liabilities + stockholder equityo Current assets: highly liquid (convert in less thana year)o Fixed assets: Tangible and Intangible (convert in more than a year) Tangible: objects Intangible: patent o Net Working Capital NWC = Current Assets – Current liabilities - Positive when cash that will be received over the next 12 months exceed cash paid out (indicate financially healthy firm)o Liquidity (Current vs. Fixed) Ability to convert to cash quickly (ability to sell)- Low liquidity (hard to sell): take discount on price in order to sell faster Liquid firms are less likely to experience financial distress- But liquid assets typically earn a lower return because itis easer to sello Trade-off to find balance between liquid and illiquid assets Illiquid assets produce higher return due to their risk- Book value vs. Market valueo Book value: on balance sheet (value) of assets, liabilities, and equity (includes depreciation of value on books)o Market value: price at which assets, liabilities, or equity can actually be bought or sold Generally Market value is more important for firms- Income Statemento Idea of cash coming into a firm Generally report revenues first and then deduct any expenses for period- Matching principle: GAAP says to show revenue when it accrues and match the expenses required to generate the revenue.o Formula: Net income = Net sales – Cost of Goods Sold – Deprecation = EBIT (Earning before interest and taxes) o EBIT – Interest paid = Taxable incomeo Taxable income – taxes = Net income - Taxeso Marginal vs. Average tax rates Marginal tax rates: percentage paid on next dollar earned; would the next dollar you make affect the tax bracket you are in Average tax rates: tax bill/ taxable incomeo Other Taxes State Local (city or town) Corporate progressive taxes- Increase tax rates when one makes more income- 8 categorieso Range from 15% to 39 % for corporationso Average tax rates max out at 35% Government has incentives on corporate taxes; may actually pay a different tax rate Smooth increase for average compared to marginal- Marginal rate very important when making decision (especially for new projects)o Example: Firm earns $4 million in taxable income What is the taxable liability? (Total paid in taxes)—use tax bracket sheet- 50,000(.34)+25,000(.25)+25,000(.34)+235,000(.39)+3,665,000(.34)=1,360,000 What is the Marginal tax rate? If the company got paid one extra dollar what would it affect the tax bracket- 34% What is the Average Tax rate: Taxable liability/ Total Income (earned)- 1,360,000/4,000,000= 34%- Cash Flowo One of the most important pieces of information that financial managers can derive from financial statemento The statement of cash flows does not provide us with same information that we are looking foro We will look at how cash is generated from utilizing assets and how it is paid to
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