Introduction

• Organizing a Business

• The Role of The Financial Manager

• Financial Markets

• Corporate Goals & Incentives

Organizing a Business

• Types of Business Organizations– Sole Proprietorships– Partnerships– Corporations– Hybrids

• Limited Partnerships

• LLP

• LLC

• PC

SoleProprietorship

Partnership Corporation

Who owns thebusiness?

The Manager Partners Shareholders

Are managersand ownersseparate?

No No Usually

What is theowner’sliability?

Unlimited Unlimited(exceptions)

Limited

Are owners &the businesstaxedseparately?

No No Yes

Organizing a Business

Financial

managersFirm's

operations

Financial

markets

(1) Cash raised from investors

(1)

(2) Cash invested in firm

(2)

(3) Cash generated by operations

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)

The Role of The Financial Manager

Financial Markets

Funds

Funds

Banks

Insurance Cos.

Brokerage Firms

Obligations

Depositors

Policyholders

Investors

Obligations

Company

Intermediary

Investor

The Role of The Financial Manager

• Investment Decisions– “Capital Budgeting”– Buy real assets that are worth more than they

cost

• Financing Decisions

—Source of Funds “Capital Markets”

—Capital Structure

Advantages of Intermediation

1 – Transaction costs/Payments mechanisms.

2 – Matching borrowers and lenders

• Borrower may want to borrow for 2 years

• May have many lenders that want to lend for a year each.

3 – Pooling of Risk

Goals of The Corporation

• Shareholders desire wealth maximization

• Do managers maximize shareholder wealth?

• Managers have many constituencies “stakeholders”

• “Agency Problems” represent the conflict of interest between management and owners

Goals of The Corporation

Agency Problem “Solutions”

1 - Compensation plans

2 - Board of Directors

3 - Takeovers

4 - Specialist Monitoring

5 – Auditors

Remark: Problems can still occur because of differences of information.

Financial Accounting

• The Balance Sheet

• The Income Statement

• The Statement of Cash Flows

• Accounting for Differences

• Taxes

The Balance Sheet

Definition

Financial statements that show the value of the firm’s assets and liabilities at a particular point in

time (from an accounting perspective).

The Balance Sheet

The Main Balance Sheet Items

Current AssetsCash & SecuritiesReceivablesInventories

+

Fixed AssetsTangible AssetsIntangible Assets

The Balance Sheet

The Main Balance Sheet Items

Current AssetsCash & SecuritiesReceivablesInventories

+

Fixed AssetsTangible AssetsIntangible Assets

Current LiabilitiesPayablesShort-term Debt

+

Long-term Liabilities

+

Shareholders’ Equity

=

Market Value vs. Book Value

Book Values are determined by GAAP

Market Values are determined by current values

Equity and Asset “Market Values” are usually higher than their “Book Values”

Market Value vs. Book Value

Example

According to GAAP, your firm has equity worth $6 billion, debt worth $4 billion, assets worth $10 billion. The market values your firm’s 100 million shares at $75 per share and the debt at $4 billion.

Q: What is the market value of your assets?

Market Value vs. Book Value

Example

According to GAAP, your firm has equity worth $6 billion, debt worth $4 billion, assets worth $10 billion. The market values your firm’s 100 million shares at $75 per share and the debt at $4 billion.

Q: What is the market value of your assets?

A: Since (Assets=Liabilities + Equity), your assets must have a market value of $11.5 billion.

Market Value vs. Book Value

Example (continued)

Book Value Balance Sheet

Assets = $10 bil Debt = $4 bil

Equity = $6 bil

Market Value vs. Book Value

Example (continued)

Book Value Balance Sheet

Assets = $10 bil Debt = $4 bil

Equity = $6 bil

Market Value Balance Sheet

Assets = $11.5 bil Debt = $4 bil

Equity = $7.5 bil

The Income Statement

Definition

Financial statement that shows the revenues, expenses, and net income of a firm over a period of time (from an accounting

perspective).

The Income Statement

Earnings Before Interest & Taxes (EBIT)

EBIT = total revenues

minus costs

minus depreciation

The Income StatementPepsico Income Statement (year end 1998)

Net Sales 22,348

COGS 9,330

Other Expenses 291

Selling, G&A expenses 8,912

Depreciation expense 1,234

EBIT 2,581

Net interest expense 321

Taxable Income 2,260

Income Taxes 270

Net Income 1,990

Profits vs. Cash FlowsDifferences

• “Profits” subtract depreciation (a non-cash expense)

• “Profits” ignore cash expenditures on new capital (the expense is capitalized)

• “Profits” record income and expenses at the time of sales, not when the cash exchanges actually occur

• “Profits” do not consider changes in working capital

The Statement of Cash FlowsPepsico Statement of Cash Flows (excerpt - year end 1998)

Net Income 1,990

The Statement of Cash FlowsPepsico Statement of Cash Flows (excerpt - year end 1998)

Net Income 1,990

Non-cash expenses

Depreciation 1,234

Other 382

Changes in working capital

A/R=(303) A/P=253 Inv=(284) other=(47) (381)

Cash Flow from Operations 3,212

The Statement of Cash FlowsPepsico Statement of Cash Flows (excerpt - year end 1998)

Net Income 1,990

Non-cash expenses

Depreciation 1,234

Other 382

Changes in working capital

A/R=(303) A/P=253 Inv=(284) other=(47) (381)

Cash Flow from Operations 3,212

Cash Flow for New Investments (5,019)

Cash Raised by New Financing 190

Net Change in Cash Position (1,617)

Taxes

• Taxes have a major impact on financial decisions

Marginal Tax Rate is the tax that the individual pays on each extra dollar of income.

Average Tax Rate is the total tax bill divided by total income.

Taxes

Example - Taxes and Cash Flows can be changed by the use of debt. Firm A pays part of its profits as debt interest. Firm B does not.

Taxes

Example - Taxes and Cash Flows can be changed by the use of debt. Firm A pays part of its profits as debt interest. Firm B does not.

Firm A

EBIT 100

Interest 40

Pretax Income 60

Taxes (35%) 21

Net Income 39

Taxes

Example - Taxes and Cash Flows can be changed by the use of debt. Firm A pays part of its profits as debt interest. Firm B does not.

Firm A Firm B

EBIT 100 100

Interest 40 0

Pretax Income 60 100

Taxes (35%) 21 35

Net Income 39 65

Taxes

FOOD FOR THOUGHT - If you were both the debt and equity holders of the firm, which would generate more cash flow to you? (assume Net Income = Cash Flow)

Firm A Firm B

Net Income 39 65

+ Interest 40 0

Net Cash Flow 79 65

Why the difference?

Firm A Firm B

Net Income 39 65

+ Interest 40 0

Net Cash Flow 79 65

• Interest is not taxed!• 40*0.35=14 (which is the difference)