1-1 What is Finance? The study of how people allocate The study of how people allocate scarce resources over time scarce resources over time Costs and benefits of financial Costs and benefits of financial decisions are: decisions are: spread out over time spread out over time not known with certainty at time of not known with certainty at time of decision decision Central concept: valuation Central concept: valuation Valuation deals with looking forward Valuation deals with looking forward
Transcript
1-1
What is Finance?
The study of how people allocate scarce The study of how people allocate scarce resources over timeresources over time
Costs and benefits of financial decisions Costs and benefits of financial decisions are:are:spread out over timespread out over timenot known with certainty at time of decisionnot known with certainty at time of decision
Central concept: valuationCentral concept: valuation Valuation deals with looking forwardValuation deals with looking forward
1-2A Simplified Organizational Chart (Figure 1.1)
Chairman of the Board andChief Executive Officer (CEO)
AdvantagesAdvantagesunlimited lifeunlimited lifeeasy transfer of ownershipeasy transfer of ownershiplimited liabilitylimited liabilityease of raising capitalease of raising capital
DisadvantagesDisadvantagesdouble taxationdouble taxationset-up and reporting costsset-up and reporting costsagency costsagency costs
1-4
SoleProprietorship Partnership Corporation
Who owns thebusiness?
The Manager Partners Stockholders
Are managersand ownersseparate?
No No Usually
What is theowner’sliability?
Unlimited Unlimited(exceptions)
Limited
Are owners &the businesstaxedseparately?
No No Yes
1-5
Goal of Financial Management
What are firm decision-makers hired to do?What are firm decision-makers hired to do?
““General Motors is not in the business of making automobiles. General Motors is in the business of making money.”
Alfred P. Sloan
Possible goalsPossible goals
Three equivalent goals of financial management:Three equivalent goals of financial management: maximize shareholder wealthmaximize shareholder wealth maximize share pricemaximize share price maximize firm valuemaximize firm value
1-6
Agency Relationships
An agency relationship exists An agency relationship exists whenever a principal hires an agent whenever a principal hires an agent to act on their behalfto act on their behalf
Within a corporation, agency Within a corporation, agency relationships exist between:relationships exist between:shareholders and managersshareholders and managersshareholders and creditorsshareholders and creditors
1-7
Shareholders versus Managers
Managers are naturally inclined to Managers are naturally inclined to act in their own best interestsact in their own best interests
But the following factors affect But the following factors affect managerial behavior:managerial behavior:compensation planscompensation plansdirect intervention by shareholdersdirect intervention by shareholdersthreat of firingthreat of firingthreat of takeoverthreat of takeoverBoard of DirectorsBoard of Directors
1-8
Shareholders versus Creditors
Shareholders could take actions to Shareholders could take actions to maximize stock price that are maximize stock price that are detrimental to creditorsdetrimental to creditors
In the long run, such actions will In the long run, such actions will raise the cost of debt and ultimately raise the cost of debt and ultimately lower stock pricelower stock price
1-9
Factors that Affect Stock Price
Projected cash flows to stockholdersProjected cash flows to stockholdersTiming of the cash flow streamTiming of the cash flow streamRisk of the cash flowsRisk of the cash flows
VALUE (price) = the discounted value VALUE (price) = the discounted value of all relevant future cash flowsof all relevant future cash flows
P = P = t t CFCFtt ×× (1 + (1 + r r ))––tt
1-10
Computing Cash Flows
Why Do We Care About This Topic?Why Do We Care About This Topic?
Financial managers need accurate forecasts of cash flows to Financial managers need accurate forecasts of cash flows to make accurate investment and financing decisionsmake accurate investment and financing decisions
Investment bankers and deal makers need to know how much Investment bankers and deal makers need to know how much to bid for a company in an acquisition and/or mergerto bid for a company in an acquisition and/or merger
Managers need to know how much cash flow is generated by Managers need to know how much cash flow is generated by assets to get feedback on their strategic decisionsassets to get feedback on their strategic decisions
Investors and creditors need to know how much cash is Investors and creditors need to know how much cash is generated from assets and operations to determine the generated from assets and operations to determine the financial solvency of a companyfinancial solvency of a company
1-11The Balance Sheet (Figure 2.1)
Total Value of LiabilitiesTotal Value of Liabilitiesand Shareholders’ Equityand Shareholders’ EquityTotal Value of Assets
Years ended December 31, 1997 and December 31, 1996($ in Millions)
Item 1997 1996
Current Assets
Cash 150.00 100.00
Accounts Receivable 250.00 200.00
Inventories 300.00 300.00
Total Current Assets 700.00 600.00
Gross Fixed Assets (at cost)
Buildings 200.00 175.00
Mach. & Equip. 100.00 75.00
Land 250.00 200.00
Construction in Progress 50.00 25.00
Total Gross Fixed Assets 600.00 475.00
Less: Accumulated depreciation 100.00 75.00
Net Fixed Assets 500.00 400.00
Total Assets 1200.00 1000.00
1-13Quincy Corporation Balance Sheet: Liability and Shareholders' Equity Account
Years ended December 31, 1997, December 31, 1996 ($ in Millions)
Item 1997 1996
Liabilities
Current Liabilities
Accounts Payable 150.00 100.00
Notes Payable 200.00 200.00
Total Current Liabilities 350.00 300.00
Long-term Debt 420.00 400.00
Total Liabilities 770.00 700.00
Shareholders' Equity
Common Stock + surplus 60.00 50.00
Retained Earnings 370.00 250.00
Total Shareholders' Equity 430.00 300.00
Total Liabilities and Shareholders'Equity 1200.00 1000.00
1-14Quincy CorporationIncome Statement
Years ended December 31, 1997 and December 31, 1996(Million $)
Item 1997 1996
Net Sales 2000.00 1,250.00
Cost of Sales (1000.00) (650.00)
Gross Profit 1,000.00 600.00
Operating Expenses:
Selling Expenses 150.00 45.00
General Expenses 250.00 100.00
Depreciation Expense 100.00 45.00
Operating Profit (EBIT) 500.00 410.00
Interest Expense 100.00 55.00
Income Before Taxes 400.00 355.00
Taxes 200.00 177.50
Net Income 200.00 177.50
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GAAP Net Income vs. Cash Flows
General Accepted Accounting Principles (GAAP) General Accepted Accounting Principles (GAAP) govern audited financial statementsgovern audited financial statements The objective of GAAP is to provide a consistent account of a firm's The objective of GAAP is to provide a consistent account of a firm's
financial status based on historical cost, where revenues and financial status based on historical cost, where revenues and expenses are matched over the appropriate time period.expenses are matched over the appropriate time period.
Cash flow does not equal GAAP net incomeCash flow does not equal GAAP net income.. GAAP recognizes revenue at time of sale, and matches expenses GAAP recognizes revenue at time of sale, and matches expenses
to these revenues, but cash flow may occur at different time.to these revenues, but cash flow may occur at different time. Depreciation and other non-cash items are included in GAAP net Depreciation and other non-cash items are included in GAAP net
income.income. Items are recorded on an accrual basis, not when the money Items are recorded on an accrual basis, not when the money
actually comes into the firm.actually comes into the firm.
Cash Flow = difference between dollars in and Cash Flow = difference between dollars in and dollars outdollars out
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Cash Flow Summary1.1. The cash flow identityThe cash flow identity
Cash flow from assets Cash flow from assets = Cash flow to creditors (bondholders)= Cash flow to creditors (bondholders)+ Cash flow to stockholders (owners)+ Cash flow to stockholders (owners)
2.2. Cash flow from assetsCash flow from assetsCash flow from assets Cash flow from assets = Operating cash flow= Operating cash flow
– Net capital spending– Net capital spending – Additions to net working capital (NWC)– Additions to net working capital (NWC)
where:where: Operating cash flow Operating cash flow = Earnings before interest and taxes (EBIT)= Earnings before interest and taxes (EBIT)
+ Depreciation – Taxes+ Depreciation – Taxes Net capital spending = Net capital spending = Ending net fixed assets – Beginning net fixed Ending net fixed assets – Beginning net fixed
3.3. Cash flow to creditorsCash flow to creditorsCash flow to creditors = Interest paid – Net new borrowingCash flow to creditors = Interest paid – Net new borrowing
4.4. Cash flow to stockholdersCash flow to stockholdersCash flow to stockholders = Dividends paid – Net new equity raisedCash flow to stockholders = Dividends paid – Net new equity raised
1-17
A Closer Look at Operating Cash Flow (OCF)
OCF = EBIT + Depreciation - TaxesOCF = EBIT + Depreciation - TaxesEBIT has already subtracted depreciation.EBIT has already subtracted depreciation.Depreciation is excluded from OCF. It is a Depreciation is excluded from OCF. It is a
non-cash item. By adding depreciation, we non-cash item. By adding depreciation, we have a cash flow number that includes costs have a cash flow number that includes costs associated with operating activities and associated with operating activities and excludes non-cash items.excludes non-cash items.
Taxes are included in OCF because the taxes Taxes are included in OCF because the taxes are paid on the revenues associated with are paid on the revenues associated with
operating activities.operating activities.
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A Closer Look at NWC
•What is additions to NWC?What is additions to NWC?
•What does this number mean? Is it a cash inflow What does this number mean? Is it a cash inflow or a cash outflow?or a cash outflow?
Account End of Year Beginning of YearCurrent AssetsCash 100 100Inventories 100 110Accounts receivable 80 100Current LiabilitiesNotes Payable 50 80Accounts Payable 180 70NWC 100+110+100-80-70=16050
2.2. Cash flow to stockholdersCash flow to stockholders
= = Dividends paidDividends paid – (Ending Common - Beg. Common) – (Ending Common - Beg. Common)
= $80 – ($60 - $50)= $80 – ($60 - $50)
= $70= $70
Check: $150 from assets = $80 to bondholders + $70 to stockholdersCheck: $150 from assets = $80 to bondholders + $70 to stockholders
1-21
Statement of Cash Flows
Summarizes the flow of cash receipts (inflows) and Summarizes the flow of cash receipts (inflows) and cash payments (outflows) during a given period of cash payments (outflows) during a given period of timetimesummarizes sources and uses of cashsummarizes sources and uses of cashreconciles change in cash balance over timereconciles change in cash balance over time
Restatement of balance sheet and income Restatement of balance sheet and income statementstatement
Operating activitiesOperating activities+ Net income+ Net income+ Depreciation+ Depreciation+ Decrease in current assets (except cash)+ Decrease in current assets (except cash)+ Increase in current liabilities + Increase in current liabilities (not notes payable)(not notes payable)
– – Any increase in current assets (except cash)Any increase in current assets (except cash)– – Decrease in current liabilities Decrease in current liabilities (not notes payable(not notes payable))
Investment activitiesInvestment activities– – (Increase in net fixed assets + Depreciation)(Increase in net fixed assets + Depreciation)
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Statement of Cash Flows, cont’d.
Financing activitiesFinancing activities
– – Decrease in notes payableDecrease in notes payable
+ Increase in notes payable+ Increase in notes payable
– – Decrease in long-term debtDecrease in long-term debt
+ Increase in long-term debt+ Increase in long-term debt
– – Decrease in common stockDecrease in common stock
+ Increase in common stock+ Increase in common stock
– – Dividends paidDividends paid
1-24
Hermetic Inc., Balance Sheet
as of December 31as of December 31($ in thousands)($ in thousands)
Identify whether an activity is an operating activity (O), investment activity (I), financing activity (F) and if it is a source (+) or use (-) of cash.
