Chapter 1

Mgt 326 Fall 2012

Why Study Finance?

How Firms are Organized

Sole proprietorship– Easy– Most common

Partnerships– Business run by more than one owner – Limited partnership – limited liability

How Firms are Organized

Limited Liability Companies – All owners have limited liability– Flow through tax benefits – Set up to protect professionals in a partnership

due to poor performance or misconduct by one partner.

Ex: malpractice suit.

How Firms are Organized

Corporations – Legally defined, artificial being, separate from its owners

Formation – Must be legally formed. – Difficult

Ownership– Shareholders are the owners.

Dividend payments are made to the shareholders at the discretion of the corporation. Payment is proportional to the amount of shares held.

Taxation– S Corp

– C Corp

How Firms are Organized

Corporations Taxation

– S Corp Taxed once All profits pass through stock holders, no tax is paid at the

corporate level

– C Corp Subject to taxation separate from the owners tax obligations In effect shareholders pay tax twice on the corporations

profits This is referred to as double taxation

How Firms are organized - summarized

Proprietor or PartnershipAdvantages- Easy to set up Owner manager make decisions Less regulated Single taxation

Disadvantages Unlimited Liability Life of the business is limited to the

life of the owner. Difficult to transfer ownership Hard to raise capital

CorporationAdvantages Liability limited to the amount

invested Easy to transfer ownership Unlimited life

Disadvantages Harder to set up Double Taxation Highly regulated by the Fed. Owner Manager conflicts

Tax Implications for Corporations

Example You are a shareholder in a corporation. The corporation earns $5.00 per share before taxes. After it has paid taxes, it will distribute the rest of its earnings to you as a dividend. The dividend is income to you so you will then pay taxes on these earnings. The corporate tax rate is 40%, and your tax rate on the dividend is 15%. How much of the earnings remain after all taxes are paid?

What do Financial Manager’s do?

Make Investment Decisions– Weigh the cost and benefit of each investment / project– Decide whether they are good uses of the available money

Make Financing Decision– Will the manager finance the decision using additional stock

or issue debt

Manage Cash Flow.– Make sure the company has enough cash to meet the day

to day obligations.

Goal of the financial Manager– Maximize the wealth of the stockholders.

What do Financial Manager’s do?

Goal of the financial Manager– Maximize the wealth of the stockholders.

Unambiguous objective Easy to Measure Public traded are perfect for this due to the large number of buyers /

sellers Forces securities to trade near their true price

The Corporate Management Team

1 Cash & Credit Mgmt2 Inventory Management3 Capital Budgeting4 Planning and Forecasting

Board of Directors

President / CEO

VP: Marketing VP Finance (CFO) VP: Manufacturing

Controller Treasurer

1Cost Accounting2Financial Accounting3Tax Management

Agency Conflicts

Agency Problems – When managers, despite being hired as the

agents of shareholders, put their own self-interest ahead of the interests of the shareholders

Agency Conflicts

What can be done to eliminate Agency Problems– Tie Performance to compensation– Shareholders can force a resignation– Hostile take over– Legal & Regulatory Environment

Sarbanes-Oxley – also known as the Truth in Securities Act

Ethics in Business

Agency Costs– Act Honestly– Deception & Fraud can have a huge & long

lasting effect on stock price Could cause bankruptcy as with Enron and WorldCom

Conflicts of Interest– Dual Function

Disclosure Sometimes law requires one party to withdraw

Ethics in Business (cont)

Information Asymmetry– One party has information the other does not

Inside information illegal Truth in Negotiations

Ethical Consequences

Bernard Ebbers – WorldCom– Guilty of Fraud – Sentenced to 25 yes jail time

Bernard Madoff– Pleaded guilty to 11 federal felonies – massive

ponzi scheme– Sentenced to 150 years in prison – Maximum

allowed

The Stock Market

The stock market provides liquidity for a company’s shares and determine the market price.

Primary Market– Issues new shares. These go to investors

Secondary Market– Shares trade between investors, with out the involvement of

the corporation.

The stock market acts as a score card for management and how well of a job they are doing, based upon the stock price.

NYSE

Physical Location Market Makers or Specialist

– Individuals on the trading floor of a stock exchange who match buyers with sellers

– They post two prices for every stock they make a market for Bid price – Ask price –

– The Specialist will buy or sell (up to a limited amount of shares) and make the trade, even if they don’t have another customer willing to take the other side of the trade.

– This way they make sure the market is liquid

NYSE cont

Auction Market – Licensed holders can go to the companies trading

posts and directly sell or buy shares

Bid Ask Spread– Transaction cost – Small spread

NASDAC

National Association of Security Dealers Automated Quotation

– Over the Counter (OTC) Market– The major difference between NYSE and NASDAC is that on

the NYSE each stock only has one market maker– On NASDAC, stocks can and do have multiple market

makers who compete with each other Each Market maker must post bid and ask prices in the

NASDAQ network where they can be viewed by all participants. The NASDAQ system posts the best prices first and fills orders

accordingly

Listing Standards

These are the requirements that have to be met to be traded on the exchange.– Require enough shares for liquidity.– The two exchanges compete over the listings of

larger companies.

Financial Institutions

Banks and Credit Unions– Deposits

Loans money to people

Insurance companies– Premiums and investment earnings

Invests mostly in bond, some stocks, using the investment income to pay claims

Mutual Funds– Peoples investments (savings)

Buys stocks bonds and other financial instruments on behalf of its investors

Financial Institutions

Pension Funds– Retirement savings contributed through the workplace

Similar to mutual funds, except with the purpose of providing retirement income.

Hedge Funds – Investments by wealthy individuals and endowments

Invests in any kind of investment in an attempt to maximize returns.

Financial Institutions

Venture Capital – Investments by wealthy individuals and

endowments Invest in start up, entrepreneurial firms

Private Equity Funds– Investments by wealthy individuals and

endowments Purchases whole companies by using a small amount of

equity and borrowing the rest.

Factors that influence stock prices

• Internal Factors (ie influenced by management)– Projected Earnings Per Share – Timing of projected earnings– Riskiness of the projected earnings– Debt Policy – Dividend Policy

Factors that influence stock prices

• External factors (ie beyond management’s control) – Antitrust laws– Environmental regulations– Product and workplace safety regulations– Federal Reserve Monetary Policy– Government Fiscal Policy – International Developments

What Jobs Can Finance majors pursue?

Private sector– Stock Broker– Personal Investment Counselor

Public Sector– Program Manager– Budget Analyst– Cost Analyst

Corporations and Small Businesses– Budget Analyst– Cost Analyst– Capital Manager– Program Manager

The Difference between Finance & Accounting

Finance– Focused on the future– Deals with uncertainty– Primarily concerned with deciding how to acquire,

generate and distribute assets & capital resources– Strategic decision making

The Difference between Finance & Accounting

Accounting– Focused on the past– Very little uncertainty– Primarily concerned with keeping track of how

assets and capital are distributed – Limited decision making

Risk

The chance that an outcome other than that which was expected will occur

For finance Risk = Uncertainty of cash flows

Rate of Return

Also known as Yield, Return on Investment (ROI), Profit Percentage

The percent increase in the price of a financial asset

Formula for calculating RoR– (Sales – COGS) / COGS– (New Price – Old Price) / Old Price

Rate of Return (cont)

In finance we are more concerned with RoR than we are Profit– Consider the 2 investments

Rate of Return (cont)

The second option has a higher profit, however the first option was more profitable because you got more money with respect to the amount of money invested.

Investments expressed as RoR can be compared on the same basis with out bias.

What are the goals of the Corporation?

The primary goal is to Maximize Shareholder Wealth– Why– How is this measured