Finance (FNCE 101)

Introduction Financial Statements Chapters 1,2,3

Professor WANG Rong

Todays Agenda

Discussion of Syllabus Introduction to Finance (Chapter 1) Business forms Financial managers Agency problems Financial markets Financial Statements (Chapters 2,3)
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Course Objectives

Introduce the key concepts of Finance Evaluate Investment Projects Value Bonds and Stocks Analyze Risk and Return Estimate Costs of Capital Capital Structure Options Help with Personal Finance

Course Readings
Textbook
Fundamentals of Corporate Finance, by Ross, Westerfield, Jordan, Lim and Tan (Asia Global Edition) You can also use Corporate Finance Fundamentals, by Ross, Westerfield and Jordan, 8th/9th edition.

Lecture notes
Available at eLearn

Course Grading

Class participation (name card): 10% Group Project

Oral Presentation: Written Report:

5% 15%

Quizzes (Two): Midterm Exam: Final Exam:

10% 20% 40%

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Course Structure - I

Homework Assignments:

will not be graded, but everyone should do

Class Participation (Name Card) Good behavior:

ask questions (including Q&A after student presentations) answer questions, help solving problems
surf internet chat SMS, etc.
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Bad behavior:

Computer policy

Course Structure - II

Quizzes

Two quizzes, 20 minutes, about 10 MCQs Closed book, closed notes, basic formulas will be provided Calculators are allowed. Cell phones are not allowed. No makeups. If you are unable to take quizzes due to a serious health problem (with MC), the first quiz (the second quiz) will be cumulated to your midterm (final exam).
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Course Structure - III

Midterm

21 Feb 2012, Friday 6pm 7:30pm

Closed-book, closed-notes, formulas will be provided. Calculators are allowed. Cell phones are not allowed. No make-ups. If you miss the midterm exam due to a health problem (with MC), your midterm will be cumulated to your final grade. If you have a time conflict, inform me no later than the 2nd week.

Course Structure - IV
Final Exam April 23th, 13PM-15PM Cumulative, Closed-book, closed-notes, 2 hours Formulas will be provided. Calculators are allowed. Cell phones are not allowed.

Group Project - I

The project is about in-depth analysis on a firms financial health, emphasizing risk-return tradeoffs and valuation. Details are posted on eLearn.
Groups will be assigned randomly and announced in week 5. Each group needs to pick a listed (public) firm and email me and your TA the company picked by the end of week 8.

To ensure that every group picks a different company, we follow a first-come first-serve system. For those who fail to meet the deadline, a randomly selected company will be assigned to you. After the deadline, no further changes will be allowed.
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Group Project - II

Suggestions on how to select a company: A listed firm (SGX, NYSE, NASDAQ) A large firm with with easy access to financial information (and preferably with regular dividend payments) Mainly focus on one industry, and easy to find competitors in the same industry (and in the same country). Some examples: Coca Cola, Starwood Hotels and Resorts, IBM, Coach Inc., Ralph Lauren, Whole Foods Market, TripAdvisor.

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Group Project - III

Grading (20% of final grade) Oral presentation (week 12&13): 5 points.

20-minute presentation + 5-minute Q&A Everybody should present. Members in a group may receive different grades based on their own performance. Week 12 Groups 1-5; Week 13 Groups 6-9

Written report (due in class of week 12 for ALL groups): 15 points.

Maximum 20 pages (excluding appendix) Late submission will be punished by 5 points. Members in a group by default get same grade for the written report. However if someone has very little contribution, he/she will receive lower grade than others.

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Financial Calculator

Examples: HP-10B, Sharp EL-733A, and Texas Instruments BA II Plus

In class, I will use Texas Instruments BA II Plus for illustration

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Teaching Assistants

G4 (Mon, SR2.8) - Daphne KOK Yuen Wah daphne.kok.2011@economics.smu.edu.sg

G5 (Tue, SR2.7) - CHUAH Chia Ern cechuah.2011@business.smu.edu.sg G6 (Wed, SR3.2) - LY Phuong Dung pdly.2011@business.smu.edu.sg

G7 (Thu, SR2.7) - Veronica KUOH Jia Hui jhkuoh.2011@economics.smu.edu.sg

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My Expectations

Preparation for class Class Participation Missed Work Honor Code Hint: If you dont understand something, ask me a question!
Preliminary Schedule see syllabus
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Your Expectations of Me

Your questions will be answered! Course Materials on eLearn Availability Office: LKCSB Rm 4042 Email: rongwang@smu.edu.sg Phone: 6828 0148 Office hours: By appointment. I will announce office hours before exams.
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What is Finance?

Finance studies and addresses the ways in which individuals, business, and organizations raise, allocate, and use monetary resources over time, taking into account the risks entailed in their projects. (from Wikipedia)

Basic areas in Finance

Corporate Finance Investments work with financial assets Financial institutions International Finance

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What is corporate finance?

Corporate finance is about corporations financial decisions.

What is a corporation?

A form of business organization Other forms of business organization also exist.

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Business Forms: Sole Proprietorship

One person owns the business

Advantages
1. 2. 3. Least regulated Owner keeps all profits Less agency issues

Disadvantages
1. Unlimited liability 2. Hard ownership transfer 3 Limited life of business 4. Limited capital

What businesses are likely to be sole proprietorships? What should be the goal of a sole proprietorship? Who gets to determine the goal?
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Business Forms: Partnership

Two or more own the business

Advantages
1. 2. 3.

Disadvantages
1. 2. 3.

Similar to sole proprietorship

Similar to sole proprietorship

What businesses are likely to be partnerships? What should be the goal of a partnership? Who gets to determine the goal?
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Business Forms: Corporation

Business owned by stockholders

Advantages
1. Easier to raise money 2. Limited liability 3. Easy ownership transfer

Disadvantages
1. Double taxation 2. Agency issues 3. Complex regulation

What businesses are likely to be corporations? What should be the goal of a corporation? Who gets to determine the goal?
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Valuation: Is it magic?

Google, Inc. (founded 1998) provides Web search and online advertising services. Market capitalization: US$154B in 2008. Asia Pacific Breweries (founded 1931, listed on the Singapore Exchange) is one of the key players in the beer industry. Today, APB oversees a portfolio of over 40 beer brands and brand variants, including Tiger Beer, Heineken, Anchor and ABC Stout. Market capitalization: SG$3.9B in 2006.
Question: Which is the largest company listed on the Singapore Exchange?
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Separation of Ownership and Control

Shareholders Board of Directors Management Other Stakeholders

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Financial Manager

The top financial manager within a corporation is usually the Chief Financial Officer (CFO)

Treasurer responsible for cash management, raising capital, and banking relationships Controller responsible for budgeting, accounting, and taxes

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Financial Management Decisions

Financing/capital structure decisions

How much capital to raise? Debt vs. equity What projects to invest in? Short-term assets and short-term liabilities

Investment/capital budgeting decisions

Working capital management

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Objective of the Financial Manager

What is the basic goal of financial management? Minimize costs? Maximize market share? Avoid bankruptcy/survive as long as possible? Maximize profit? Maximize shareholder value?

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Agency Problems

Do managers really maximize shareholder wealth? Agency Problems represent the conflict of interest between management and shareholders.

Managers do not always act in the best interests of shareholders, and they sometimes make decisions that destroy shareholder value.
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Solutions to Agency Problems

Monitoring

The Board of Directors & Lenders & Speicalists

Compensation Plans

stock and options

Takeovers Legal and Regulatory Requirements

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Corporate Scandals & SOX

WorldCom 2001 Report $3.8 billion of operating expenses as investments and overstated the income. Assets: 103.9 Billion Enron 2001 Concealed $1.7 billion losses Assets: 65.5 Billion Sarbanes-Oxley Act of 2002 the Public Company Accounting Reform and Investor Protection Act of 2002 What is the largest bankruptcy in the world?

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Flow of Cash Between the Firm and the Financial Markets

(2)

(1)

Firm's operations
(3)

Financial Manager

(4a)

Financial Markets (Investors)

(4b)
(1) (2) (3) (4a) (4b) Money raised from investors Money invested in firm to buy real assets Money generated by real assets Money reinvested Money returned to investors

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Financial Markets

Primary market A market where the firm sells its securities to public for the first time Secondary markets A market in which the securities issued by firms are traded Auction Markets (a physical location): Listed securities trade in an organized exchange, e.g. NYSE Dealer markets (OTC, Over-the-counter): securities are bought from or sold to a dealer (NASDAQ)
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Financial Statements
Chapter 2,3

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Major Financial Statements

Balance Sheet Income Statement Statement of Cash Flows (not covered) Statement of the sources & uses of cash Operating Activities Investing Activities Financing Activities
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The Balance Sheet

The balance sheet is a snapshot of the firms assets and liabilities at a given point in time.
Assets are listed in order of liquidity Ease of conversion to cash Without significant loss of value Balance Sheet Identity Assets = Liabilities + Stockholders Equity Stockholders Equity = Assets Liabilities (shareholders are residual owners)
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The Balance Sheet

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Income Statement

The income statement is more like a video of the firms operations for a specified period of time. Income Statement Identity Net Income = Revenues - Expenses Matching principle show revenue when it accrues and match the expenses required to generate the revenue How is balance sheet and income statement linked to each other?
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US Corporation Income Statement

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U.S. Corporate Tax Rates (progressive tax rates)

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Example: Marginal Vs. Average Rates

Marginal vs. average tax rates Marginal the percentage paid on the next dollar earned Average the tax bill / taxable income

Suppose your firm earns $200,000 in taxable income.

What is the firms tax liability? What is the marginal tax rate? What is the average tax rate?

If you are considering a project that will increase the firms taxable income by $100,000, what tax rate should you use in your analysis?
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Singapore Corporate Tax Rate

Flat tax rate on income Its going down!

Tax rate 40% 33% Year 2001 2002 Tax rate 25.5% 24.5%

Year 1986 and before 1987-1989

1990
1991-1992 1993 1994-1996 1997-2000

32%
31% 30% 27% 26%

2003-2004
2005-2007 2008-2009 2010-2013

22%
20% 18% 17%
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Financial Statement Analysis Ratio Analysis (I)

Ratios provide relative measures to interpret firm performance (strength and weakness). There are five categories of ratios. Each category measure a different dimension of a firms performance (i.e. strengths & weaknesses). 1. Liquidity 2. Solvency or Leverage 3. Asset Management or Turnover 4. Profitability 5. Market value
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Category 1: Liquidity Ratios

What do they measure: How well can the firm pay its bills without undue stress. A high ratio indicates liquid, but too high may mean the firm is inefficient.

Examples: Current ratio= Current assets / Current liabilities

Quick ratio = (Current assets Inventory) / Current liabilities

Cash ratio = Cash / Current liabilities
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Category 2: Solvency (Leverage) Ratios

What do they measure? Measures the firms long-run ability to meet its obligations. Too high of a ratio could lead to financial distress Too low of a ratio could indicate the firm is not utilizing all the benefits of debt.
Total debt ratio = (Total assets Total equity) / Total assets Equity multiplier = Total assets / Total equity
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Examples:

Category 3: Asset Management and Turnover Ratios

What do they measure? How efficiently does the firm use its assets to generate sales Investigates long-term and current assets.

Examples: Inventory turnover = Cost of goods sold/ Inventory

Total asset turnover = Sales / Total assets

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Category 4: Profitability Ratios

What do they measure? They show how well the firm is able to control expenses and generate revenue (the difference being profits). Examples: Profit margin = Net income/ Sales

Return on assets (ROA) = Net income/Total assets Return on equity (ROE) = Net income/Total equity

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Du Pont Identity
ROE =Net Income/Total Equity =(NI/Sales)*(Sales/Assets)*(Assets/Total Equity) =Profit margin*Assets Turnover*Equity Multiplier Du Pont Identity tells us that that ROE is affected by three things: Operating efficiency (as measured by profit margin) how well it controls costs Asset use efficiency (as measured by total asset turnover) how well does it manage its assets Financial leverage (as measured by the equity multiplier)
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Category 5: Market value ratios

What do they measure?

They tell us a firms market value relative to its accounting measure.

Examples: PE ratio=price per share/earnings per share Market to Book ratio = market value per share / book value per share
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What is the market value of a firm?

How do we measure Value? Book Value (BV) Market Value (MV)! BV is based on historical cost of assets. MV measures current value of assets and liabilities MV is forward looking, it reflects a firms potential growth.

What is the market value of a firm?

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Homework Assignments

Read syllabus, the group project description, chapters 1,2,3 Supplemental Readings

IBM_Annual_report_1994 Basic Accounting Glossary

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Next Class

Financial Tools Chapters 5,6 Name Card Get a Financial calculator. Before the class,

Set the number of decimal places to four or higher Set P/Y (which means number of payments per year) to one.
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Texas Instruments BA II Plus

Procedure: Changing the Number of Decimal Places Press 2nd FORMAT DEC= is displayed with the current decimal-place setting. Enter the number of decimal places to be displayed (0 through 9) and press ENTER. To return to the standard-calculator mode, press 2nd Quit Procedure: Setting P/Y = 1 Press 2nd P/Y , then enter 1 and press ENTER. To return to the standard-calculator mode, press 2nd Quit.
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