1 1 Chapter Foundations Slides Developed by: Terry Fegarty Seneca College

11Chapt

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Chapt

er FoundationsFoundations

Slides Developed by:

Terry FegartySeneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2

Chapter 1 – Outline (1)

• Two Main Areas of Finance Financial Assets Financial Markets Financial System Raising money Field of Finance

• Financial Management The Price of Securities Finance and Accounting


Chapter 1 – Outline (2)

The Importance of Cash Flow Finance and Economics

• Forms of Business Organization The Proprietorship Form The Corporate Form

• Goals of Management Stakeholders and Conflicts of Interest The Agency Problem Creditors Versus Shareholders


Two Main Areas of Finance

1. Investments and financial markets

2. Financial management of corporations The financial system involves flows of

money and paper between them.


Real Assets and Financial Assets

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

• Financial asset —a security representing a claim to income. Two principal types: shares (stocks) and bonds


Types of Financial Assets

• Share (Stock)—ownership interest in a company Entitled to a share of the firm’s profits, either

dividends or future growth

• Bond—debt interest in a company Entitled to interest and repayment of

principal


Uses of Financial Assets

• Companies issue financial assets to raise money.

• Use that money to buy real assets for running their businesses

• Financial assets are purchased by investors (people or other companies) to earn a return with funds they have saved

• Investments can be made directly or indirectly (ex; buying units in a mutual fund)


Financial Markets

• Financial assets are issued by corporations and bought by investors in a financial market

A framework or organization in which people can buy/sell securities • Stock market (TSX, OTC, NYSE)--entire network of

brokers and exchanges connected together• Stockbroker (broker)--person licensed to trade

securities for a commission


Primary Markets and Secondary Markets

• Primary market—market where securities are initially sold (Initial Public Offering or I.P.O.)

• Secondary market—market (TSX, etc.) where investors trade securities among themselves after the I.P.O. Most transactions are of this type


The Financial System

• Investments Making decisions about buying and selling

stock and bonds

• Financial management Decisions about raising money and how to

spend it


Figure 1.1: Simplified Financial System


Raising Money

• Financing means raising money to acquire something

• Forms of Financing Issuing shares (equity financing) Borrowing money (debt financing)

• Bank• Issuing bonds• Leasing

Internal financing (retaining earnings)• Considered equity financing


Field of Finance

• The field of finance includes raising money and investing money

• Changing Focus of Finance Finance used to be narrowly limited to

financial market activity However has expanded to include

• Portfolio formation and analysis• A portfolio is a collection of securities

• Financial management within an organization


Financial Management

• Financial Management is management and control of money and money-related operations within a business

• Executive in charge of finance department Chief Financial Officer (CFO); AKA: VP of

Finance) • Typically reports directly to the President of the

corporation



• Functions of the finance department include: Receiving payments from customers Making payments to suppliers and employees Oversee spending by other departments Evaluating capital expenditures Borrowing funds Selling shares Paying dividends Keeping records

Accounting department is included in the broad definition

of finance.



• Capital Expenditures Finance department is in charge of:

• Advising other executives on which assets a firm should purchase

• Acquiring another firm• Expanding operations

• A different product line• Current operations expanding to another country

• Deciding how those assets will be financed• Equity (Share issue or retained earnings)• Debt (Bond Issue or bank loan)



• Oversight Finance department must also perform an

oversight function• Looking over everyone’s shoulder to make certain

money is being used effectively• For example,

• Are manufacturing costs too high?• Are advertising costs too high?


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

• Investors buy securities for future cash flows expected from them Price investors are willing to pay depends on

expectations of how well the companies are likely to do



• Link between company management and investors comes from relationship between price and expected financial results Everything firm does is evaluated by market

and ‘graded’ by either an , , or no change in security price



• Does management care what ‘grade’ it receives? YES! Why?

• Management will need to issue new securities in the future (to raise $) and therefore want a high security price

• Shareholders own firm and if share price declines shareholders will be unhappy


Finance and Accounting

• Accounting: system of record-keeping designed to portray firm’s operations in a fair/unbiased manner Generate financial statements which are

provided to the marketplace• Finance: a process of decision-making

related to raising money, analyzing results, etc. Uses output generated by accountants as

inputs in finance


Finance and Accounting

• Finance department generally consists of both accounting department and the treasury department Controller is in charge of accounting

department Treasurer deals with finance activities

• Both of these positions report to Chief Financial Officer (CFO)


Figure 1.2: Finance Department Organization


The Importance of Cash Flow

• Accounting attempts to reflect firm’s financial results in a way that represents what is physically occurring

• Finance is interested in how cash is flowing (or expected to flow) We need a cash amount because we’ll be

looking at returns on money invested, and you can’t invest a non-cash number• Cash is King


The Importance of Cash Flow

Q: In 2005 we purchased a $1,000 asset that will be amortized over five years using straight-line amortization. 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 amortization.

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

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The Language of Finance

• Accounting is the language of finance Thus all finance professionals need some

accounting knowledge•Financial analyst needs to know LOTS of

accounting because she investigates companies and makes recommendations concerning their value in market (must decipher complex financial statements as part of that process)

•Stockbroker does not need as thorough an understanding because he generally trades securities based on the financial analyst’s recommendation


Financial Theory—The Relationship with Economics

• Financial theory developed from economics Modern financial theory began as a branch of

economics in the 1950s• Today finance is viewed as a separate field

• Scholars in both fields make observations between business world and government and attempt to model the behaviour


Figure 1.3: The Influence of Accounting, Economics and Financial Theory

on Financial Management


Forms of Business Organization and Their Financial Impact

• Businesses can be legally organized as A sole proprietorship A partnership A corporation

• Legal organization has an impact on Raising money Taxation Financial liability


The Proprietorship Form

• Getting started Easy to do

• Raising money If entrepreneur decides to go outside the firm

to raise money, he can obtain a loan• Lending money is risky

• Best possible outcome: repayment of principal and interest

• Worst possible outcome: lose everything

• Thus, most lenders require collateral• Many entrepreneurs use their house as collateral


The Proprietorship Form

• Profit is taxed as personal income to business owner

• Is taxed only once• Taxed at personal income tax rates


The Corporate Form

• Getting started Requires a legal incorporation process


The Corporate Form

• Raising Money Money for a corporation can be raised by

• Borrowing• A corporation faces same issues as a sole proprietorship

when borrowing money

• Offering shares to investors• Major financial advantage of corporate form• If less than a 50% interest is sold, original owner still

maintains effective control• Owning shares is risky

• Best possible outcome: may get rich• Worst possible outcome: may lose all of your

investment


The Corporate Form

• Taxation When business makes a profit, taxes are paid

twice• The corporation pays a tax at the corporate tax

rate• Dividends paid to shareholders are taxed at the

individual’s personal tax rate• However, dividend tax credits are allowed to

individuals to reduce or eliminate effect of double taxation


The Truth About Limited Liability

• In sole proprietorship, business owner stands to lose personal property if all assets of the business are insufficient to cover all liabilities

• In a corporation, limited liability states that a shareholder is not liable for a corporation’s debts Implies that the most shareholder can lose is 100%

of his investment in the shares Personal guarantees make entrepreneurs liable for

loans made to their corporate business• Reduces value of limited liability


Goals of Management

• Economics—goal is to maximize profit But what about R&D?

• If you eliminate R&D you’ll increase short-term profit and hurt long-term profit

• Finance—shareholders own company so goal is to maximize wealth of the shareholders, generally by maximizing share price Shareholder wealth maximization is not same as

profit maximization Share price incorporates both short-term and long-

term! • If R&D were eliminated share price might not rise, but drop


Stakeholders

• Stakeholders: Constituencies of company who have vested interest in the way firm is operated. Include Shareholders Employees Customers Community Management Creditors Suppliers


Stakeholders and Conflicts of Interest 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 shareholders

• This represents a conflict of interest between shareholders and employees

• Something that benefits one group and takes away from another

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Management—A Privileged Stakeholder Group• Management is a privileged stakeholder group• The ownership of a widely held company is very

dispersed so no one has enough control to influence management IBM has almost 2 billion shares outstanding, and over

600,000 shareholders

• This allows top management to become entrenched in positions controlling large amounts of resources

• Management is able to use these resources for their own benefit


The Agency Problem

• Management (agent) is controlling resources owned by shareholders (principal) and may not make the decisions shareholders want


The Agency Problem

• The Abuse of Agency Privileges and luxuries provided to executives

are called perquisites or ‘perks’• Example—management compensation

• Management receives exorbitant salaries/bonuses ($50+ million) while the company performance is poor

• Additional perks include use of boats, airplanes, country club memberships, etc.


The Agency Problem

OwnersOwners ManagersEmployeesManagersEmployees

Management may attempt to maximizeits own welfare instead of the owners’ wealth.

Management may attempt to maximizeits own welfare instead of the owners’ wealth.

Conflict of interestsConflict of interests


Managing The Agency Problem

• Efforts to manage agency problem include Monitor management (audits) Tie management bonuses to corporate stock

performance via a stock option or to corporate profit


Creditors Versus Shareholders—A Financial Conflict of Interest

• A creditor—anyone owed money by a business including lenders, vendors, employees, government

• Actions by borrowing company that are riskier than before they borrowed place creditors at additional risk

• Lenders generally put clauses in loan agreements to prevent this For example, incurring additional debt


Creditors Versus Shareholders

OwnersOwners CreditorsCreditorsConflict of interestsConflict of interests

Solution:Creditors insert protective covenants in

loan agreements

Solution:Creditors insert protective covenants in

loan agreements

Documents

1 1 Chapter Foundations Slides Developed by: Terry Fegarty Seneca College