Chapter 1

Finance

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The study of how people and businesses evaluate investments and raise capital to fund them

Three questions addressed by the study of finance: 1. CAPITAL BUDGETING: What long term investments should the firm undertake? 2. CAPITAL STRUCTURE: How should the firm raise money to fund these investments? 3. WORKING CAPITAL MANAGEMENT: How can the firm best manage its cash flows as they arise in its day-to-day operations? Three types of business organizations: 1. Sole Proprietorship o Owned by a single individual who is entitled to all the firms profits and who is also responsible for the firms debt o No separation between the business and the owner when it comes to debts or being sued (when sued, he or she can lose not only all the investments but also personal assets) o Very easy to form: no forms to file and partners to consult o Limited access to outside sources of financing (owners raise money by investing their own funds and by borrowing from a bank) 2. Partnership i. General Partnership An association of two or more person who come together as coowners for the purpose of operating a business for profit No separation between the general partnership and its owners with respect to debts or being sued Profits of the partnership are taxed to the partners as personal income

Provides access to equity, or ownership, as well as financing from multiple owners in return for partnership shares or units of ownership ii. Limited Partnership 2 classes of partners: general and limited General Partner runs the business and faces unlimited liability for the firms debts Limited Partner only liable up to the amount he or she invested

Life of the partnership is tied to the life of the general partner Difficult to transfer ownership of the general partners interest in the business but the limited partners shares can be transferred to another owner without the need to dissolve the partnership

3. Corporation o Very large sums of money are needed to build a corporation o An artificial being, invisible, intangible, and existing only in the contemplation of law U.S. Supreme Court Chief Justice John Marshall o Most common choice for firms that are growing and need to raise money o Provides the easiest access to capital o Functions separately and apart from its owners (shareholders or stockholders) o 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 o Owners liability is confined to the amount of their investment in the company o Life of the business is not tied to the status of the investors o Ease of raising a capital o Legally owned by its current set of stockholders, or owners, who elect a board of directors o Board of Directors then appoint management who are responsible for determining the firms direction and policies o Double Taxation of earnings that are paid out in the form of dividends (when a corporation earns profits, it pays taxes on that profit and pay some of that profit back to the shareholders in the form of dividends, then the shareholders pay personal income taxes on those dividends) o Limited Liability Company (LLC) a cross between a partnership and a corporation Combines the tax benefits of a partnership (no double taxation of earnings) with the limited liability benefit of a corporation (liability is limited to money invested) The Role of the Financial Manager: Oversees the firms financing decisions, including the management of the firms cash position (delegated to the treasurer in larger firms) as well as corporate reporting and general accounting (delegated to the controller in larger firms)

Very important task is to design incentive compensation plans that better align the interests of managers with the stockholders Make financial decisions regarding long-term investments, financing, and management of short-term cash needs: Maximizing the wealth of shareholders

Ethics in Business and Agency Problems: The Sarbanes-Oxley Act to protect investors by improving accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes and mandates that senior executives take individual responsibility for the accuracy and completeness of the firms financial reports Safeguards the interests of stockholders by providing greater protection against accounting fraud and financial misconduct Agency Problems conflict of interest between the stockholders and the managers (agents) of a firm

The Four Basic Principles of Finance: 1. Money has a time value. Money received today is worth more than money received in the future. 2. There is a risk-return tradeoff. We wont take on additional risk unless we expect to be compensated with additional return. 3. Cash flows are the source of value. Profit is an accounting concept designed to measure a business performance over an interval of time. Cash flow is the amount of cash that can actually be taken out of the business over this same interval. 4. Market prices reflect information. Investors respond to new information by buying and selling such that prices reflect what is known. The speed with which investors act and the way that prices respond reflects the efficiency of the market.

The Sustainable Rate of Growth the maximum rate of growth in sales that the firm can sustain while maintaining its present capital structure (debt and equity mix) and without having to sell new common stock the rate at which a firms sales can grow if it wants to maintain its present financial ratios and does not want to resort to the sale of new equity shares Sustainable Rate of Growth (g*) = ROE(1-b) ROE or Return on Equity = Net Income/Common Equity b the firms dividend payout ratio or Dividends/Net Income (1-b) plowback ratio: indicates the fraction of earnings that are reinvested or plowed back into the firm ROE can also be written as: o ROE = (Net Income/Sales) x (Sales/Assets) x (Assets/Common Equity) A firms sustainable growth is determined by its ROE and its dividend policy

*The firms assets must vary at a constant percent of sales (i.e., even fixed assets expand and contract directly with the level of firm sales). *The firms liabilities must all vary directly with firm sales. The firms management will expand its borrowing (both spontaneous and discretionary) in direct proportion with sales to maintain its present ratio of debt to assets. *The firm pays out a constant proportion of its earnings in common stock dividends regardless of the level of firm sales.

Chapter 3
The Four Basic Financial Statements: 1. Income Statement 2.

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Includes the revenue, the expenses, and the profit the firm has earned Balance Sheet Assets (everything the firm owns), liabilities (the firms debts), and shareholders equity (the money invested by the owners) Cash Flow Statement Cash received and spent over a specified period of time Statement of Shareholders Equity Common and preferred stock accounts, the retained earnings account, and changes to owners equity

3. 4.

Why study financial statements? Financial statement analysis to assess the final condition of the firm Financial control to monitor and control the firms operations Financial forecasting and planning to provide a universally understood format for describing a firms operations

What are the accounting principles used to prepare financial statements? 1. The revenue recognition principle. The revenue should be included in the firms income statement for the period in which a) its goods and services were exchanged for either cash or accounts receivable or b) the firm has completed what it mist do to be entitled to cash 2. The matching principle. Letting the expenses follow the revenues 3. The historical cost principle. Most assets and liabilities are reported in the firms financial statements on the basis of the price the firm paid to acquire them

The Income Statement Also called a profit and loss statement Measures the amount of profit generated by a firm over a given period (usually a year or a quarter) Revenues (Sales) Expenses = Profits Revenues are determined in accordance with the revenue recognition principles and expenses are then matched to these revenues using the matching principle

Cost of Goods Sold cost of producing or acquiring the products or services that the firm sold Depreciation Expense non-cash expense used to allocate the cost of the firms long-lived assets over the useful lives of the assets Earnings Before Interests and Taxes (EBIT) net operating income Interest Expense not included in operating expenses Earnings Before Taxes Taxable Income Earnings Per Share how much income the firm made on a per share basis o Earnings Per Share = Net Income/No. of Common Shares Dividends Per Share the amount of dividends the firm pays for each share o Dividends Per Share = Total Dividends/No. of Common Shares Gross Profit Margin the firms markup on its cost of goods sold per dollar of sales o Gross Profit Margin = Gross Profit/Sales o Markup Percentage = Gross Profit/Cost of Goods Sold Operating Profit Margin = EBIT/Sales Net Profit Margin captures the effects of all the firms expenses and indicates the percentage of revenues left over after interest and taxes have been considered o Net Profit Margin = Net Income/Sales The successive profit margins get smaller and smaller; we can dissect a firms performance and identify the expenses that are out of line (important indicator of how well a firm is doing financially) Format: Revenues Less: Cost of Goods Sold Equals: Gross Profit Less: Operating Expenses Equals: Net Operating Incomes Less: Interest Expense Equals: Earnings before Taxes Less: Income Taxes Equals: Net Income

Corporate Taxes Taxable Income often referred to in its income statement as earnings before taxes o = Net Operating Income-Interest Expenses

Marginal Tax Rate the tax rate that the company will pay on its next dollar of taxable income Average Tax Rate = Cumulative Tax Liability/Taxable Income

The Balance Sheet A snapshot of the firms financial position on a specific date Assets = Liabilities + Shareholders Equity Market Value the price that an asset would trade for in a competitive market Par Value stated or face value a firm puts on each share of stock prior to it being offered for sale Paid in Capital additional amount of capital the firm raised when a buyer purchases a stock for more than its par value Retained Earnings the portion of net income that has been retained from prior years operations Stockholders Equity = Per Value of Common Stock + Paid in Capital + Retained Earnings Liquidity refers to the speed with which the asset can be converted into cash without loss of value Net Working Capital = Current Assets Current Liabilities

The Cash Flow Statement Used to explain changes in a firms cash balances over a period of time by identifying all of the sources and uses of cash for the period spanned by the statement Change in Cash Balance = Ending Cash Balance Beginning Cash Balance Source of Cash any activity that brings cash into the firm (such as when the firm sells goods and services or sells an old piece of equipment that it no longer needs Use of Cash any activity that causes cash to leave the firm (such as the payment of taxes, the purchase of a new equipment, and etc.) Change in Retained Earnings = Net Income/Dividends Sources of Cash Decrease in an asset account Increase in a liability account Increase in an owners equity account Uses of Cash Increase in an asset account Decrease in a liability account Decrease in an owners equity account

Operating Activities a companys core business including sales and expenses (anything that affects the net income for the period)

Investing Activities purchase and sale of long-term assets such as PPE Financing Activities changes in the firms use of debt and equity (sale of new shares of stock, repurchase of outstanding shares, payment of dividends Format: o Beginning Cash Balance Plus: Cash Flow from Operating Activities Plus: Cash Flow from Investing Activities Plus: Cash Flow from Financing Activities o Equals: Ending Cash Balance

Chapter 17
Strategic Plan how the firm plans to make money in the future

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Direct application of Principle 2: There is a risk-reward tradeoff. Answers the ff. questions: o Who are we and what do we do? o Who are our customers? o Who are our competitors and how do we compete (price, quality, features, etc.)?

Long-Term Financial Plan Generally spans three to five years and serves as the basis for developing the shortterm financial plan Process begins with a forecast of firm sales, which then serves as the basis for forecasting the firms financial position at the end of each year of the planning horizon Consists of a pro forma income statement and balance sheet Step 1: Construct a Sales Forecast o Generally made using a) information about any past sales trend that is expected to carry over into the period being forecast and b) information about the influence of any anticipated events that might materially affect the sales trend o Ex. Start of a major advertising campaign that would provide a boost to future sales, or a change in the firms pricing policy that could expand the firms market Step 2: Prepare Pro Forma Financial Statements o Include both an income statement and a balance sheet o Percent of Sales method most common technique for preparing pro forma financial statements Expresses expenses, assets, and liabilities for a future period as percentages of sales Percentages can come from the most recent financial statements, from an average computed over several years, from the judgment of the analyst, or from some combination of these methods

Step 3: Estimate the Firms Financing Needs o Using the pro forma statements, we can extract the cash flow requirements of the firm

o Firms financial statements are not prepared on a cash basis but instead use something called the accrual method o However, financial statements can be used to estimate the firms financing needs in cash terms Sources of Spontaneous Financing accounts payable and accrued expenses Sources of Discretionary Financing raising financing with notes payable, long-term debt, and common stock requires a managerial decision or exercise of managerial discretion o The retention of some or all of the firms earnings is also a discretionary source of financing since the retention of earnings is the result of the firms management having decided not to pay the earnings out in dividends to the firms stockholders Discretionary Financing Needs financing sources that are not spontaneously generated by the firms day-to-day operations but require a managerial decision DFN = Pro Forma Total Assets Accounts Payable Accrued Expenses Notes Payable Long-Term Debt Common Equity Pro Forma Total Assets = Total Financing Needs Accounts Payable & Accrued Expenses = Projected Spontaneous Sources of Financing

Notes Payable, Long-Term Debt & Common Equity = Existing Discretionary Sources of Financing 1. Projected Spontaneous Sources of Financing & Existing Discretionary Sources of Financing = Projected Sources of Financing Short-Term Financial Plan Extends out to one year Presented in the form of a cash budget that contains a great deal of detail concerning the firms cash receipts and disbursements Four Elements of a Cash Budget: 1. Cash Receipts 2. Cash Disbursements 3. Net Change in Cash for the Period 4. New Financing Needed o A tool for predicting the amount and timing of the firms future financing requirements o A tool to monitor and control the firms operations