Presentation 1 Finance 101 BUAD 340

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1 Presentation 1 Finance 101 BUAD 340

2 1. What is finance? 2. Three types of business organizations Overview 3. The goal of the financial manager 4. The eight basic principles of finance

3 What is Finance? Finance is the study of how people and businesses evaluate investments and raise capital to fund them. (how to get and use money) ADCF 310/Fall2018/Week 1/Dr. Minor 3

4 Three Questions Addressed by the Study of Finance What long-term investments should the firm undertake? (capital budgeting decisions - how to spend the money) How should the firm fund these investments? (capital structure decisions - how to get the money) How can the firm best manage its cash flows as they arise in its day-to-day operations? (working capital management decisions) ADCF 310/Fall2018/Week 1/Dr. Minor 4

5 ADCF 310/Fall2018/Week 1/Dr. Minor

6 What is finance? At the macro level, finance is the study of financial institutions and financial markets and how they operate within the financial system in both the American and global economies. At the micro level, finance is the study of financial planning, asset management, and fund raising for business and financial institutions Chapter 1, Liuren Wu

7 What is finance? (con t) Financial Services Design and delivery of advice and financial products to individuals, businesses, and government Managerial Finance Duties of the financial manager ADCF 310/Fall2018/Week 1/Dr. Minor

8 Three types of business organizations 1. Sole proprietorships 2. Partnerships Hybrids 3. Corporations Chapter 1, Liuren Wu

9 Sole Proprietorship It is a business owned by a single individual that is entitled to all the firm s profits and is responsible for all the firm s debt. There is no separation between the business and the owner when it comes to debts or being sued. Sole proprietorships are generally financed by personal loans from family and friends and business loans from banks. Advantages: Easy to start No need to consult others while making decisions Taxed at the personal tax rate Disadvantages: Personally liable for the business debts Ceases on the death of the proprietor Chapter 1, Liuren Wu

10 Partnership A general partnership is an association of two or more persons who come together as co-owners for the purpose of operating a business for profit. There is no separation between the partnership and the owners with respect to debts or being sued. Advantages: Relatively easy to start Taxed at the personal tax rate Access to funds from multiple sources or partners Disadvantages: Partners jointly share unlimited liability Chapter 1, Liuren Wu

11 Limited Partnership In limited partnerships, there are two classes of partners: general and limited. The general partners runs the business and face liability for the firm s debts, while the limited partners are only liable on the amount invested. One of the drawback of this form is that it is difficult to transfer the ownership of the general partner. Chapter 1, Liuren Wu

12 Corporation Corporation is an artificial being, invisible, intangible, and existing only in the contemplation of the law. Corporation can individually sue and be sued, purchase, sell or own property, and its personnel are subject to criminal punishment for crimes committed in the name of the corporation. Corporation is legally owned by its current stockholders. The Board of directors are elected by the firm s shareholders. One responsibility of the board of directors is to appoint the senior management of the firm. ADCF 310/Fall2018/Week 1/Dr. Minor 12

13 Corporate Management Team 1.2 Ownership versus Control of Corporations In a corporation, ownership and direct control are typically separate. Board of Directors Elected by shareholders Have ultimate decision-making authority Chief Executive Officer (CEO) Board typically delegates dayto-day decision making to CEO.

14 1.2 Ownership versus Control of Corporations (cont'd) Ownership and Control In a corporation, there may be thousands of shareholders, many with different priorities. Even if all of the shareholders agree on the goals of the firm, the goals must be implemented. This is the job of the management team. How can the shareholders be sure that the management team will implement their goals?

15 Principal-Agent Problem Managers may act in their own interest rather than in the best interest of the shareholders. One potential solution is to tie management s compensation to firm performance. How should performance be measured? 1.2 Ownership versus Control of Corporations (cont'd)

16 CEO Performance 1.2 Ownership versus Control of Corporations (cont'd) If a CEO is performing poorly, shareholders can express their dissatisfaction by selling their shares. This selling pressure will drive the stock price down. Hostile Takeover Low stock prices may entice a Corporate Raider to buy enough stock so they have enough control to replace current management. The stock price will rise after the new management team fixes the company.

17 Corporate Bankruptcy Reorganization Liquidation 1.2 Ownership versus Control of Corporations (cont'd)

18 Corporation (con t) Advantages Liability of owners limited to invested funds Life of corporation is not tied to the owner Easier to transfer ownership Easier to raise Capital Disadvantages Greater regulation Double taxation of dividends ADCF 310/Fall2018/Week 1/Dr. Minor 18

Raising Money Borrowing Corporation Same issues faced by sole proprietorship BUT owner can now offer stock (equity) to investors If sell less than 50% can maintain control From the investor

19 Raising Money Borrowing Corporation Same issues faced by sole proprietorship BUT owner can now offer stock (equity) to investors If sell less than 50% can maintain control From the investor s perspective Stock is a risky investment but the reward may be worth it» Worst possible outcome: lose entire investment» Best possible outcome: get rich 19 ADCF 310/Fall2018/Week 1/Dr. Minor

20 Concept Connection Example 1-2 Tax Consequences of Business Form A business earns $100,000 before taxes. Owner wants to take the earnings home. Tax rates: Corporate - 34% (now 21%) Personal - 30% (now new rates) Compare total tax bills under corporate and proprietorship forms of organization ADCF 310/Fall2018/Week 1/Dr. Minor 20

21 Example 1.1

22 Example 1.1 (cont'd)

23 Hybrid Organizations These organizational forms provide a cross between a partnership and a corporation. Limited liability company (LLC) combines the tax benefits of a partnership (no double taxation of earnings) and limited liability benefit of corporation (the owner s liability is limited to what they invest). S-type corporation provides limited liability while allowing the business owners to be taxed as if they were a partnership that is, distributions back to the owners are not taxed twice as is the case with dividends in the standard corporate form. Chapter 1, Liuren Wu

24 ADCF 310/Fall2018/Week 1/Dr. Minor 24

25 Figure 1.1 Types of U.S. Firms ADCF 310/Fall2018/Week 1/Dr. Minor 1-25

26 The goal of the financial manager The goal of the financial manager must be consistent with the mission of the corporation to maximize firm shareholder s wealth (as measured by share prices). While managers have to cater to all the stakeholders (such as consumers, employees, suppliers, etc.), they need to pay particular attention to the owners of the corporation, i.e., shareholders. If managers fail to pursue shareholder wealth maximization, they will lose the support of investors and lenders. The business may cease to exist and ultimately, the managers will lose their jobs! Chapter 1, Liuren Wu

27 Conflicts of Interest An Illustration Employees want management to build a gym Benefit healthy employees are more productive Cost reduces stockholders return Conflict of interest between stockholders and employees What if request for healthier working conditions? ADCF 310/Fall2018/Week 1/Dr. Minor 27

28 How to Reduce Agency Problems? Monitoring (Examples: Reports, Meetings, Auditors, board of directors, financial markets, bankers, credit agencies) Compensation plans (Examples: Performance based bonus, salary, stock options, benefits) Others (Examples: Threat of being fired, Threat of takeovers, Stock market, regulations such as SOX) The above will help to reduce agency problems/costs.

29 Corporate mission statements: examples To achieve sustainable growth, we have established a vision with clear goals: maximizing return to shareholders while being mindful of our overall responsibilities. part of Coca-Cola s mission statement Our final responsibility is to our stockholders...when we operate according to these principles, the stockholders should realize a fair return. part of Johnson & Johnson s credo Optimize for the long-term rather than trying to produce smooth earnings for each quarter. - Google Chapter 1, Liuren Wu

30 Accounting and Finance Broad Portrayal vs. Cash Flow Accounting statements portray physical activity in numbers Descriptive Historical E.g. Depreciation The focus in Finance is on future cash flow In finance: Cash is King 30 ADCF 310/Fall2018/Week 1/Dr. Minor

31 Finance and Accounting Finance department generally consists of both the accounting and treasury departments Controller is in charge of the accounting department Treasury department deals with other financial activities 31 ADCF 310/Fall2018/Week 1/Dr. Minor

32 Figure 1-2 Finance Department Organization 32 ADCF 310/Fall2018/Week 1/Dr. Minor

33 How Does Finance Fit into the Firm s Organizational Structure? In a corporation, the Chief Financial Officer (CFO) is responsible for managing the firm s financial affairs. Figure 1-2 shows how the finance function fits into a firm s organizational chart. ADCF 310/Fall2018/Week 1/Dr. Minor 33

34 ADCF 310/Fall2018/Week 1/Dr. Minor 34

35 Concept Connection Example 1-1 Accounting Records and Cash Flow A $1,000 asset depreciated straight-line over five years: Accounting perspective Portrait Over Time Initial $1,000 cost becomes an asset on books $200 per year depreciation reduces profit Book value shrinks as depreciation accumulates Finance perspective Focus On Cash Flow Depreciation deduction saves cash by reducing tax It took a $1,000 cash outflow to acquire the asset Where did the money come from Finance had to raise that money 35 ADCF 310/Fall2018/Week 1/Dr. Minor

Level depends on job Financial analyst needs to know LOTS of

36 Accounting is the language of finance The Language of Finance All finance professionals need some knowledge of accounting Level depends on job Financial analyst needs to know LOTS of accounting Stockbrokers not as much ADCF 310/Fall2018/Week 1/Dr. Minor 36

37 Financial Theory The Relationship with Economics Modern financial theory began as a branch of economics in the 1950s Originally called financial economics Theoretical tools are very similar Finance is a separate but still related field 37 ADCF 310/Fall2018/Week 1/Dr. Minor

38 Figure 1-3 The Influence of Accounting, Economics and Financial Theory on Financial Management 38 ADCF 310/Fall2018/Week 1/Dr. Minor

39 Eight Principles of Finance Handout ADCF 310/Fall2018/Week 1/Dr. Minor 39

Presentation 1 Finance 101 BUAD 340

Presentation 1 Finance 101 BUAD 340 1. What is finance? 2. Three types of business organizations Overview 3. The goal of the financial manager 4. The eight basic principles of finance What is Finance?