1© 2008 Thomson South-Western

Chapter 1

Foundations

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An Overview of FinanceAn Overview of Finance

Investments and financial markets

Financial management of corporations○ Fields are separate but related

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Financial AssetsFinancial Assets

Real asset—an object that provides a service, such as a house, car, art, coin…

Financial asset—a document representing a claim to future income○ Stock represents ownership interest○ Bond represents a debt relationship

Investing involves buying financial assets in the hope of earning more money (a return)○ Investments can be made directly or

indirectly through a mutual fund

A Security is a financial asset that can be traded among investors

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Raising MoneyRaising Money

The most common use of the word finance involves raising money to acquire assetsForms of Financing○ Issuing stock - equity financing○ Borrowing money - debt financing

• Bank• Issuing bonds• Leasing is like borrowing

○ Internal financing - retaining earnings

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Raising MoneyRaising Money

The field of finance deals with both raising and investing money, but:

Changing Focus of Finance○ Past - finance was limited to

financial market activity○ Now - it includes:

• Goals and activities of investors: Portfolios • The financial management of organizations

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Financial ManagementFinancial Management

Functions of the finance department:○ Keeping records○ Receiving payments from customers○ Making payments to suppliers○ Borrowing funds○ Purchasing assets○ Selling stock○ Paying dividends○ Analysis of business decisions○ Oversight of other departments

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Business DecisionsBusiness Decisions

Finance department provides analyses to:○ Determine which assets are purchased

• Acquiring another firm• Expanding operations

○ Decide how those assets are financed• Equity• Debt

Oversight○ Finance department oversees how

other departments spend money

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The Price of Securities—A Link The Price of Securities—A Link Between the Firm and the MarketBetween the Firm and the Market

Two sides of finance – investments and financial management – connected since firms sell securities to investors in financial markets

Investors buy securities for the future cash flows expected from them

Link between company management and investors comes from this relationship between price and expected financial results

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Finance and AccountingFinance and Accounting

Accounting○ 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 ○ Process of decision-

making related to raising money, analyzing results

○ Use the output generated by accountants as inputs in finance

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Finance Department OrganizationFinance Department Organization Figure 1.2

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The Importance of Cash FlowThe Importance of Cash Flow

Accounting creates statements that are designed to portray what is physically occurring in numbers

Finance is concerned with current and future cash flow

In finance: Cash is King

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The Importance of Cash FlowThe Importance of Cash Flow

Q: Example: In 1999 we purchased a $1,000 asset that will be depreciated over five years using straight-line depreciation. Explain how that asset will be viewed from both an accounting and finance viewpoint.

A: Accounting: The initial cost of the asset of $1,000 will be reflected on the books as will the $200 annual depreciation.

Finance: We are interested in the $1,000 cash outflow and the taxes saved from the depreciation deduction—not the depreciation itself.

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The Language of FinanceThe Language of Finance

Accounting is the language of finance

○ Finance professionals need some accounting knowledge

• Level of accounting knowledge depends on job

– Financial analyst needs to know LOTS of accounting– Stockbrokers do not need as much

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The Truth About The Truth About Limited LiabilityLimited Liability

Limited liability states that a stockholder is not liable for a corporation’s debts○ Implies that the most a stockholder can lose is 100%

of his investment in the stock○ True for owners not involved in the business

However, for owner operated small businesses○ Personal guarantees make entrepreneurs liable for

loans made to their business○ Legal system holds individuals liable for negligence○ These destroy the value of limited liability

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S-Type Corporations and LLCsS-Type Corporations and LLCs

Major advantage: Treated as a partnership with respect to federal income taxes○ LLC is replacing S-type

Government encourages formation of small businesses because they create jobs○ S-type corporations and LLCs

• Let small businesses avoid double taxation• Offer limited liability• Offer the ability to sell stock to raise money

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Goals of ManagementGoals of Management

Economics—goal is to maximize profit○ Runs into short/long run problems○ What about R&D?

Finance—goal is to maximize stockholders’ wealth by maximizing stock price○ Bypasses the concern of whether the short-term

or long-term is more important, because stock price set in the financial market incorporates both!

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Stakeholders and Stakeholders and Conflicts of InterestConflicts of Interest

Stakeholders that have an interest in the way the firm is operated include: Stockholders Employees Customers Community Management Creditors Suppliers

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Conflicts of InterestConflicts of InterestAn IllustrationAn Illustration

Example: Employees want management to build an athletic facility on corporate grounds○ Benefit—more effective employees (feel better,

happier, therefore more productive)○ Cost—will come from profits that belong to

stockholders○ Represents a conflict of interest between

stockholders and employees○ What if the request was for healthier working

conditions?

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Creditors Versus Stockholders—A Creditors Versus Stockholders—A Financially Important Conflict of InterestFinancially Important Conflict of Interest

Creditor - anyone owed money by a business including lenders, vendors, employees, or the government

If actions of the borrowing firm become

riskier than before loan, creditors/lenders

are subject to more risk○ But risk taking rewards all go to stockholders

Lenders put clauses in loan agreements to prevent this