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An Overview of Finance

Investments and financial markets Financial management of corporations

Fields are separate but related

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Financial Assets

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

Financial asset—a document representing a claim to future income Stock represents ownership interest Bond represents a debt relationship

Investing involves buying financial assets in the hope of earning more money (a return) Investments can be made directly or indirectly

through a mutual fund

A Security is a financial asset that can be traded among investors

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Raising Money

The most common use of the word finance involves raising money to acquire assets

Forms of Financing Issuing stock - equity financing Borrowing money - debt financing

Bank Issuing bonds Leasing is like borrowing

Internal financing - retaining earnings

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Raising Money

The field of finance deals with both raising and investing money, but:

Changing Focus of Finance Past - finance was limited to

financial market activity Now - it includes:

Goals and activities of investors: Portfolios The financial management of organizations

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Financial Management

Functions of the finance department: Keeping records Receiving payments from customers Making payments to suppliers Borrowing funds Purchasing assets Selling stock Paying dividends Analysis of business decisions Oversight of other departments

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Business Decisions

Finance department provides analyses to: Determine which assets are purchased

Acquiring another firm Expanding operations

Decide how those assets are financed Equity Debt

Oversight Finance department oversees how other

departments spend money

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

Two sides of finance – investments and financial management – connected since firms sell securities to investors in financial markets

Investors buy securities for the future cash flows expected from them

Link between company management and investors comes from this relationship between price and expected financial results

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Finance and Accounting

Accounting System of record-

keeping designed to portray a firm’s operations in a fair/unbiased manner

Generate financial statements which are provided to the marketplace

Finance Process of decision-making related to raising money, analyzing results

Use the output generated by accountants as inputs in finance

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Finance Department Organization Figure 1.2

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The Importance of Cash Flow

Accounting creates statements that are designed to portray what is physically occurring in numbers

Finance is concerned with current and future cash flow

In finance: Cash is King

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The Importance of Cash Flow

Q: Example: In 1999 we purchased a $1,000 asset that will be depreciated over five years using straight-line depreciation. 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 depreciation.

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

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The Language of Finance

Accounting is the language of finance

Finance professionals need some accounting knowledge Level of accounting knowledge depends

on job Financial analyst needs to know LOTS of accounting Stockbrokers do not need as much

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The Truth About Limited Liability

Limited liability states that a stockholder is not liable for a corporation’s debts Implies that the most a stockholder can lose is 100% of

his investment in the stock True for owners not involved in the business

However, for owner operated small businesses Personal guarantees make entrepreneurs liable for loans

made to their business Legal system holds individuals liable for negligence These destroy the value of limited liability

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S-Type Corporations and LLCs

Major advantage: Treated as a partnership with respect to federal income taxes LLC is replacing S-type

Government encourages formation of small businesses because they create jobs S-type corporations and LLCs

Let small businesses avoid double taxation Offer limited liability Offer the ability to sell stock to raise money

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Goals of Management

Economics—goal is to maximize profit Runs into short/long run problems What about R&D?

Finance—goal is to maximize stockholders’ wealth by maximizing stock price Bypasses the concern of whether the short-term or

long-term is more important, because stock price set in the financial market incorporates both!

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Stakeholders and Conflicts of Interest

Stakeholders that have an interest in the way the firm is operated include: Stockholders Employees Customers Community Management Creditors Suppliers

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Conflicts of InterestAn Illustration

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

stockholders Represents a conflict of interest between stockholders

and employees What if the request was for healthier working

conditions?

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Creditors Versus Stockholders—A Financially Important Conflict of Interest

Creditor - anyone owed money by a business including lenders, vendors, employees, or the government

If actions of the borrowing firm become

riskier than before loan, creditors/lenders

are subject to more risk But risk taking rewards all go to stockholders

Lenders put clauses in loan agreements to prevent this