An Overview of Financial Management

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An Overview of Financial Management

• Timothy R. Mayes, Ph.D.

FIN 3300 Chapter 1
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What is Corporate Finance

• Corporate finance is really about making business
  decisions
• Corporate finance is primarily concerned with
  three areas
• Capital budgeting
• Capital structure
• Working capital management

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Other Subject Areas of Finance

• Aside from corporate finance, there are a wide
  variety of topics that are studied by financial
  economists
• Investments (personal and corporate)
• Banking
• Insurance
• Real estate
• These are very broad subject areas that
  frequently overlap

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Some Fundamental Principles

• Before we begin to study corporate finance in
  detail, there are two fundamental concepts that
  must be understood
• The correct goal of the firm
• The risk/return tradeoff
• These two concepts underlie every major technique
  that we will study

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The Incorrect Goal of the Firm

• Most people have been taught that the goal of the
  firm is to maximize current profits
• This goal is inadequate for at least three
  reasons
• It ignores the time value of money
• It ignores risk
• It can lead to a preoccupation with short-term
  results which, in turn, can lead to sub-optimal
  long-term results

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The Correct Goal of the Firm

• The correct goal of the firm is to maximize
  shareholder wealth (i.e., shareholders equity)
  or, equivalently, to maximize the firms stock
  price.
• By this we mean to imply that the managers of the
  firm work for the shareholders
• For this reason, they have a duty to make
  investments that are expected to increase
  shareholder wealth
• Further, they have a duty to take all investments
  that are expected to increase shareholder wealth

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The Goal of U.S. West Inc.

• From the U.S. West Annual Report to Shareowners
  1988
• Our mission is to provide quality products and
  services to customers in responsive and
  innovative ways in order to create the highest
  possible value for our investors through
  long-term growth and profitability
• (emphasis added)

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The Agency Problem

• Because managers work for the shareholders, they
  are considered to be agents for the shareholders.
• Occasionally, managers may act in their own best
  interest, rather than in the interest of their
  shareholders
• This is known as an agency problem

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Agency Costs

• There are two types of costs associated with the
  agency problem
• Direct agency costs are the loss in shareholder
  wealth due to managerial misconduct
• Indirect agency costs are the costs of avoiding
  the agency problem

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The Risk/Return Tradeoff

• Throughout financial theory, we assume that
  individuals are risk averse
• This means that individuals prefer less risk to
  more risk
• However, a risk averse individual will accept
  almost any level of risk as long as they are
  properly compensated
• We assume that the risk-return tradeoff is a
  linear function (there is no good evidence that
  it isnt)

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The Risk/Return Tradeoff Graphically

• Assume that there are two projects A and B
• Project B is riskier than project A
• Therefore, we expect that B will, on average over
  time, earn a higher return than A
• Otherwise, nobody would ever invest in B

Return
B
A
B
A
Risk
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Legal Forms of Organization

• There are several legal forms that an
  organization may take
• Each form has advantages and disadvantages
• We will discuss the three major forms
• Sole proprietorships
• Partnerships
• C Corporations

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The Sole Proprietorship

• A sole proprietorship is a business that is owned
  by a single person
• Benefits
• Easy and inexpensive to start
• Drawbacks
• Unlimited liability
• Life of business limited to life of owner
• Difficult to raise funds

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The General Partnership

• A general partnership is similar to a
  proprietorship, but more than one person owns it
• Advantages
• Fairly easy to start up
• Income taxed as personal income
• Disadvantages
• Life of partnership limited to life of partners
• Unlimited joint and several liability
• Difficult to transfer the business

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The Limited Partnership

• Limited partnerships are similar to general
  partnerships, but there are two kinds of
  partners
• Limited partners are investors only. They have
  limited liability, but they are not allowed to
  participate in the day to day operation of the
  business
• General partners have unlimited liability, but
  they also have operational control of the business

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The C Corporation

• A corporation is a legally created being with
  most of the rights and duties of ordinary
  citizens
• Advantages
• Owners have limited liability
• Ownership is easily transferred
• Disadvantages
• Relatively difficult and expensive to start up
• Double taxation of income

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The Income Statement

• The income statement provides a summary of the
  revenues and expenses of a company during an
  accounting period
• Income statements may be compiled for any period
  of time (annual, quarter, month, etc.)

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Important Notes about the IS

• The income statement includes only revenues and
  expenses
• These revenues and expenses are for a particular
  period of time and are not cumulative
• Depreciation is a non-cash expense
• Dividends paid to stockholders are not
  deductible, but 30of dividends received are
  counted as taxable income

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Depreciation and Cash Flow

• Depreciation is a non-cash expense that is
  subtracted from revenues when calculating net
  income
• Because of depreciation, net income does not
  represent the funds that a firm has available for
  expansion or paying dividends
• Instead of net income, financial analysts are
  generally concerned with cash flow
• Cash Flow Net Income Non-Cash Expenses
• Operating Cash Flow EBIT Non-Cash Exp - Taxes

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The Balance Sheet

• The balance sheet shows the amount of assets,
  liabilities and equity of a firm at a point in
  time
• Assets are the things that a firm owns
• Liabilities are the debts of the firm
• Equity is the difference between assets and
  liabilities

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Notes on the Balance Sheet

• Accumulated depreciation is an accumulation
  account
• Common equity is made up of
• Common stock
• Additional paid-in capital
• Retained earnings
• Retained earnings is an accumulation account, and
  changes each period according to the formula

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The Statement of Cash Flows

• This statement shows where a firms funds came
  from and how they were used
• Three parts
• Funds from Operations
• Funds from Investing
• Funds from Financing

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Sources vs. Uses of Funds

• Essentially, there are two types of transactions
  that a firm engages in
• Those that increase the cash balance are referred
  to as sources of funds
• Those that decrease the cash balance are referred
  to as uses of funds

Source( )
Use( - )
Asset
Liability
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Why Do We Pay Taxes?

• There are at least three reasons that we pay
  taxes
• To raise revenues
• To achieve social objectives
• To manipulate the economy

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Calculating Corporate Income Taxes
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Corporate Taxes Graphically
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Marginal vs. Average Tax Rates

• Tax rates are commonly discussed in two different
  ways
• The marginal tax rate is the rate that will be
  paid on the next dollar of taxable income
• The average tax rate is the average rate that is
  paid on each dollar of taxable income
• The marginal tax rate is the rate that is
  appropriate to use for decision making purposes

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Corporate Taxes Example 1
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Corporate Taxes Example 2
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Depreciation

• Accountants define depreciation as, a systematic
  method of allocating the cost of an asset over
  its useful life.
• For tax purposes, we arent allowed to deduct the
  full cost of an asset in the year of purchase.
  Instead, we must deduct the cost over the life of
  the asset through depreciation
• In finance, we tend to think of depreciation as a
  way of reducing taxes

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Straight-line Depreciation

• Straight-line depreciation assumes that the value
  of an asset declines equally in each year of its
  life

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MACRS Depreciation

• Generally speaking, we prefer to receive cash
  flows sooner rather than later
• Ideally, we would like to be able to deduct the
  full cost of an asset at the time of purchase
• However, except for small assets, this is not
  allowed
• The IRS does allow accelerated depreciation which
  is an improvement over straight-line because it
  allows quicker tax savings

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A Note on the Focus of this Class

• Throughout this class we assume that the firms
  we discuss are corporations
• However, most of the concepts that we discuss are
  relevant to all organizational forms
• Many (if not all) of the concepts are even
  relevant to your personal life