Download What is Finance?

1-1
What is Finance?
 The study of how people allocate scarce
resources over time
 Costs and benefits of financial decisions
are:
 spread out over time
 not known with certainty at time of decision
 Central concept: valuation
 Valuation deals with looking forward
A Simplified Organizational Chart (Figure 1.1)
Board of Directors
Chairman of the Board and
Chief Executive Officer (CEO)
President and Chief
Operations Officer (COO)
Vice President
Marketing
Vice President
Production
Vice President
Finance (CFO)
Controller
Treasurer
Cash Manager
Credit Manager
Tax Manager
Cost Accounting
Manager
Capital
Expenditures
Financial
Planning
Financial
Accounting
Manager
Data Processing
Manager
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The Corporation
Advantages
 unlimited life
 easy transfer of ownership
 limited liability
 ease of raising capital
Disadvantages
 double taxation
 set-up and reporting costs
 agency costs
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Sole
Proprietorship
Partnership
Corporation
Who owns the
business?
The Manager
Partners
Stockholders
Are managers
and owners
separate?
What is the
owner’s
liability?
Are owners &
the business
taxed
separately?
No
No
Usually
Unlimited
Unlimited
(exceptions)
Limited
No
No
Yes
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Goal of Financial Management
 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 goals
 Three equivalent goals of financial management:
 maximize shareholder wealth
 maximize share price
 maximize firm value
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Agency Relationships
An agency relationship exists
whenever a principal hires an agent
to act on their behalf
Within a corporation, agency
relationships exist between:
shareholders and managers
shareholders and creditors
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Shareholders versus Managers
Managers are naturally inclined to
act in their own best interests
But the following factors affect
managerial behavior:
 compensation plans
 direct intervention by shareholders
 threat of firing
 threat of takeover
 Board of Directors
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Shareholders versus Creditors
Shareholders could take actions to
maximize stock price that are
detrimental to creditors
In the long run, such actions will
raise the cost of debt and ultimately
lower stock price
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Factors that Affect Stock Price
Projected cash flows to stockholders
Timing of the cash flow stream
Risk of the cash flows
VALUE (price) = the discounted value
of all relevant future cash flows
P = t CFt × (1 + r )–t
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Computing Cash Flows
Why Do We Care About This Topic?
 Financial managers need accurate forecasts of cash flows
to make accurate investment and financing decisions
 Investment bankers and deal makers need to know how
much to bid for a company in an acquisition and/or merger
 Managers need to know how much cash flow is generated
by assets to get feedback on their strategic decisions
 Investors and creditors need to know how much cash is
generated from assets and operations to determine the
financial solvency of a company
The Balance Sheet (Figure 2.1)
Total Value of Liabilities
and Shareholders’ Equity
Total Value of Assets
Current
Assets
Net
Working
Capital
Current Liabilities
Long-Term Debt
Fixed Assets
1. Tangible fixed
assets
2. Intangible
fixed assets
Shareholders’ Equity
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Quincy Corporation
Balance Sheet Statement: Asset Account
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Years ended December 31, 1997 and December 31, 1996
($ in Millions)
Item
1997
1996
Cash
150.00
100.00
Accounts Receivable
250.00
200.00
Inventories
300.00
300.00
700.00
600.00
Buildings
200.00
175.00
Mach. & Equip.
100.00
75.00
Land
250.00
200.00
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
1200.00
1000.00
Current Assets
Total Current Assets
Gross Fixed Assets (at cost)
Construction in Progress
Total Assets
Quincy Corporation
Balance Sheet: Liability and Shareholders' Equity Account
Years ended December 31, 1997, December 31, 1996
($ in Millions)
Item
1997
1996
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
60.00
50.00
Retained Earnings
370.00
250.00
Total Shareholders' Equity
430.00
300.00
1200.00
1000.00
Liabilities
Current Liabilities
Shareholders' Equity
Common Stock + surplus
Total Liabilities and Shareholders'
Equity
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Quincy Corporation
Income Statement
Years ended December 31, 1997 and December 31, 1996
(Million $)
Item
Net Sales
1997
2000.00
1996
1,250.00
Cost of Sales
(1000.00)
(650.00)
Gross Profit
1,000.00
600.00
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
Operating Expenses:
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GAAP Net Income vs. Cash Flows
 General Accepted Accounting Principles (GAAP)
govern audited financial statements
 The objective of GAAP is to provide a consistent account of a firm's
financial status based on historical cost, where revenues and
expenses are matched over the appropriate time period.
 Cash flow does not equal GAAP net income.
 GAAP recognizes revenue at time of sale, and matches expenses
to these revenues, but cash flow may occur at different time.
 Depreciation and other non-cash items are included in GAAP net
income.
 Items are recorded on an accrual basis, not when the money
actually comes into the firm.
 Cash Flow = difference between dollars in and
dollars out
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Cash Flow Summary
1. The cash flow identity
Cash flow from assets
2. Cash flow from assets
Cash flow from assets
where:
Operating cash flow
Net capital spending =
Change in NWC
=
= Cash flow to creditors (bondholders)
+ Cash flow to stockholders (owners)
= Operating cash flow
– Net capital spending
– Additions to net working capital (NWC)
= Earnings before interest and taxes (EBIT)
+ Depreciation – Taxes
Ending net fixed assets – Beginning net fixed
assets + Depreciation
Ending NWC – Beginning NWC
3. Cash flow to creditors
Cash flow to creditors = Interest paid – Net new borrowing
4. Cash flow to stockholders
Cash flow to stockholders = Dividends paid – Net new equity raised
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A Closer Look at Operating Cash Flow
(OCF)
 OCF = EBIT + Depreciation - Taxes
 EBIT has already subtracted depreciation.
 Depreciation is excluded from OCF. It is a noncash item. By adding depreciation, we have a
cash flow number that includes costs
associated with operating activities and
excludes non-cash items.
 Taxes are included in OCF because the taxes
are paid on the revenues associated with
operating activities.
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A Closer Look at NWC
Account
Current Assets
Cash
Inventories
Accounts receivable
Current Liabilities
Notes Payable
Accounts Payable
NWC
End of Year
Beginning of Year
100
100
80
100
110
100
50
180
80
70
50
100+110+100-80-70=160
•What is additions to NWC?
•What does this number mean? Is it a cash inflow
or a cash outflow?
Cash Flow Summary for Quincy
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A. Cash flow from assets
1. Operating cash flow
= EBIT + Depreciation – Taxes
= $500 + 100 – 200
= $400
2. Additions to Net Working Capital (-/-)
= Ending NWC – Beginning NWC
= $350 – $300
= $50
3. Net capital spending (-/-)
= End. net fixed assets + Depreciation – Beg. net fixed assets
= $500 + 100 – 400
= $200
4. Cash flow from assets
= OCF – Additions to NWC – Net Capital spending
= $400 – 50 – 200
= $150
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Cash Flow Summary for Quincy, cont’d.
B. Cash flow to creditors and stockholders
1. Cash flow to creditors
= Interest paid – (Ending LTD - Beg. LTD)
= $100 – ($420 - $400)
= $80
2. Cash flow to stockholders
= Dividends paid – (Ending Common - Beg. Common)
= $80 – ($60 - $50)
= $70
Check: $150 from assets = $80 to bondholders + $70 to stockholders
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Statement of Cash Flows
 Summarizes the flow of cash receipts
(inflows) and cash payments (outflows)
during a given period of time
 summarizes sources and uses of cash
 reconciles change in cash balance over time
 Restatement of balance sheet and income
statement
 3 primary categories
 operating activities
 investing activities
 financing activities
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The Statement of Cash Flows
 Operating activities
 + Net income
 + Depreciation
 + Decrease in current assets (except cash)
 + Increase in current liabilities (not notes payable)
 – Any increase in current assets (except cash)
 – Decrease in current liabilities (not notes payable)
 Investment activities
 – (Increase in net fixed assets + Depreciation)
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Statement of Cash Flows, cont’d.
 Financing activities
 – Decrease in notes payable
 + Increase in notes payable
 – Decrease in long-term debt
 + Increase in long-term debt
 – Decrease in common stock
 + Increase in common stock
 – Dividends paid
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Hermetic Inc., Balance Sheet
as of December 31
($ in thousands)
Assets
1995
1996
$
$
Current assets
Cash
45
50
Accounts receivable
260
310
Inventory
320
385
Total
$ 625
$ 745
985
$1610
1100
$1845
Fixed assets
Net plant and equipment
Total assets
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Hermetic Inc., Balance Sheet
Liabilities and equity
1995
1996
$ 210
$ 260
110
175
$ 320
$ 435
205
225
Common stock and
paid-in surplus
290
290
Retained earnings
795
895
$1085
$1185
$1610
$1845
Current liabilities
Accounts payable
Notes payable
Total
Long-term debt
Stockholders’ equity
Total
Total liabilities and equity
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Hermetic Inc., Income Statement
($ in thousands)
Net sales
Cost of goods sold
Depreciation
Earnings before interest
and taxes
Interest
Taxable income
Taxes
$710.00
480.00
30.00
$200.00
20.00
180.00
53.45
Net income
$126.55
Retained earnings
$100.00 
Dividend = $26.55
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Cash Flow from Assets
Cash flow from assets:
Operating cash flow:
EBIT
+ Depreciation
– Taxes
Net capital spending:
Ending net fixed assets
– Beginning net fixed assets
+ Depreciation
$
+
–
$
$ 1,100.00
– 985.00
+
30.00
$ 145.00
Change in net working capital:
Ending net working capital
$
– Beginning net working capital –
$
Cash flow from assets:
200.00
30.00
53.45
176.55
$
310.00
305.00
5.00
26.55
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Cash Flow from Assets, cont’d.
Total cash flow to creditors and stockholders:
 Cash flow to creditors:
Interest paid
$
20.00
– Net new borrowing
– 20.00
$
0.00
Dividends paid
$
26.55
– Net new equity raised
-
0.00
$
26.55
$
26.55
 Cash flow to stockholders:
Cash flow to creditors and stockholders
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Hermetic Inc., Statement of Cash Flows
 Operating activities
 + Net income
+ 126.55
 + Depreciation
+
30.00
 + Increase in payables
+
50.00
 – Increase in receivables
–
50.00
 – Increase in inventory
–
65.00
91.55
 Investment activities
 – Increase in net fixed assets
– 115.00
 – Depreciation
–
30.00
(145.00)
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Hermetic Inc., Statement of Cash Flows
 Financing activities
 + Increase in notes payable
+
65.00
 + Increase in long-term debt
+
20.00
 + Increase in equity
 – Dividends
0.00
–
26.55
58.45
Putting it all together
91.55 – 145.00 + 58.45 = 5.00
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.
Activity
Increase in Accounts
Payable
Type of Activity
Operating
Source or Use of Cash
Source
Increase in Inventories
Operating
Sale of a manufacturing
plant
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Use
Investment
Source
Financing
Source
Issue common stock