Introduction to Finance

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Introduction to Finance
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What is Finance?

• Finance is the study of how people and businesses
  evaluate investments and raise capital to fund
  them.

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Corporate Finance addresses the following three
questions

1. What long-term investments should the firm
   choose?
2. How should the firm raise funds for the selected
   investments?
3. How should short-term assets be managed and
   financed?

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Forms of Business Organization

• The Sole Proprietorship
• The Partnership
• The Corporation

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Sole Proprietorship

• It is a business owned by a single individual who
  is entitled to all of the firms profits and is
  responsible for all of the firms debt.
• The sole proprietors typically raise money by
  investing their own funds and by borrowing from a
  bank.

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Sole Proprietorship (cont.)

• Advantages
• Easy to start
• No need to consult others while making decisions
• Organization taxed at the personal tax rate
• Disadvantages
• Owner is personally liable for the businesss
  debt
• The business ceases on the death of the
  proprietor
• Hard to raise money

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Partnership General

• A general partnership is an association of two or
  more persons who come together as co-owners for
  the purpose of operating a business for profit.

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Partnership (cont.)

• Advantages
• Relatively easy to start
• Organization taxed at the personal tax rate
• Access to funds from multiple sources or partners
• Disadvantages
• Partners jointly share unlimited liability
• It is not always easy to transfer ownership

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Partnership Limited

• In limited partnerships, there are two classes of
  partners general and limited.
• The General Partner runs the business and faces
  unlimited liability for the firms debts
• The Limited Partner does not run the business and
  is only liable up to the amount invested.

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Corporation

• Are the big organizations. Generally established
  when very large sums of money are required.
• Main defining characteristic is the separately of
  ownership (shareholders) from control
  (management)
• The Board of directors are elected by the
  shareholder, and the board appoints the senior
  management of the firm.

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Corporation (cont.)

• Advantages
• Liability of owners is limited to invested funds
• Life of corporation is not tied to the owner
• Easier to transfer ownership
• Easier to raise Capital
• Disadvantages
• Greater regulation
• Double taxation of dividends

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Limited Liability Company (LLC)

• Limited liability company (LLC) combines the tax
  benefits of a partnership (no double taxation of
  earnings) with the limited liability benefit of
  corporation (the owners liability is limited to
  what they invest).

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Comparison
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Five Basic Principles of Finance

1. Time Value of Money
2. Risk-Return Trade-off
3. Cash is King
4. Market Prices Reflect Expectations/News
5. People do what is best for them, unless you make
   them change their mind

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Time Value of Money

• A dollar today is worth more than a dollar
  tomorrow
• We can invest the dollar today and earn interest.
  Therefore, in the future we have the dollar
  invested plus interest

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Risk-Return Trade-off

• No one likes risk for its own sake. Therefore
  people will only take on more risk if they are
  compensated with higher returns
• Higher the risk higher expected return
• Note expected return may not be equal to the
  realized return.

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Cash is King

• Profit, Earnings, Net Income are accounting
  numbers designed to measure performance.
• These numbers can be manipulated
• Cash flows are the actual dollars flowing in and
  out of the company and cant be manipulated as
  easy
• It is possible for a firm to report profits but
  have no cash.

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Cash is King Follow on

• Financial decisions should only consider
  incremental cash flow
• i.e. the difference between the cash flows the
  company will produce with the new investment and
  what it would make without the investment.

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Market Prices Reflect News

• Investors react quickly to news/information and
  decisions made by managers.
• Good News gt Higher stock prices
• Bad News gt Lower stock price.

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The Goal of Financial Managers

• What is the correct goal?
• Maximize profit?
• Minimize costs?
• Maximize market share?
• Maximize shareholder wealth?

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The Financial Manager

• The Financial Managers increase shareholder
  wealth by
• Selecting value creating projects
• Capital Budgeting Decision
• Making smart financing decisions
• Capital Structure Decision

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Financial Markets
Investors
Firms
Sue
Bob
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Quick Quiz

1. What are the three basic questions Financial
   Managers must answer?
2. What are the three major forms of business
   organization?
3. What is the goal of financial management?
4. What is the difference between a primary market
   and a secondary market?

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Financial Statements and Cash Flow
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Financial Statements

• Company managers, investors, and outside analysts
  use financial statements to conduct
• Cash flow analysis
• Performance (ratio) analysis
• The SEC requires U.S. companies to produce
  financial statements conforming to Generally
  Accepted Accounting Principles (GAAP), developed
  by the Financial Accounting Standards Board
  (FASB).

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Basic Financial Statements

• The accounting and financial regulatory
  authorities mandate the following four types of
  financial statements
• Balance Sheet
• Income Statement
• Cash Flow Statement
• Statement of Shareholders Equity

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The Balance Sheet

• A snapshot of the firms accounting value at a
  specific point in time
• What does the company look like today
• The Balance Sheet Identity is
• Assets Liabilities Stockholders Equity
• Left Hand Side of the balance sheet must equal
  the Right Hand Side

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Balance Sheet
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U.S. Composite Corporation Balance Sheet
The assets are listed in order by the length of
time it would normally take a firm with ongoing
operations to convert them into cash. Cash is
the most liquid with intangible assets being the
least liquid.
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Balance Sheet Analysis

• When analyzing a balance sheet, the Finance
  Manager should be aware of three concerns
• Liquidity
• Debt versus Equity
• Value versus Cost

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Liquidity

• Refers to the ease and quickness with which
  assets can be converted to cashwithout a
  significant loss in value
• Generally the more liquid the asset the lower the
  rate of return
• Current assets are more liquid than fixed assets
• The more liquid a firms assets, the less likely
  the firm is to experience problems meeting
  short-term cash obligations (Ex. payroll)
• A profitable but illiquid firm will experience
  financial distress

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Debt versus Equity

• Debt ? Liability
• Promise to payout cash, an IOU
• Equity is the residual
• Assets Liabilities Equity
• Debt represents a senior claim on firm assets
• If the firm goes bankrupt debt holders get paid
  before equity holders

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Value versus Cost

• Accountants are historians, they care about what
  something cost when purchase
• Under GAAP, financial statements carry assets at
  cost
• Market value is the price at which assets,
  liabilities, and equity could actually be bought
  or sold, TODAY
• Cost and Market Value are two completely
  different concepts
• What did we pay for it, versus what can we sell
  it for

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The Income Statement

• Measures financial performance over a specific
  period of time
• How has the company performed?
• The accounting definition of income is
• Revenue Expenses Income
• Generally the Income Statement is comprised of
  several parts

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U.S.C.C. Income Statement
Total operating revenues
2,262
The operations section of the income statement
reports the firms revenues and expenses from
principal operations.
Cost of goods sold
1,655
Selling, general, and administrative expenses
327
Depreciation
90
Operating income
190
Other income
29
Earnings before interest and taxes
219
Interest expense
49
Pretax income
170
Taxes
84
Current 71
Deferred 13
Net income
86
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U.S.C.C. Income Statement
Total operating revenues
2,262
The non-operating section of the income statement
includes all financing costs, such as interest
expense.
Cost of goods sold
1,655
Selling, general, and administrative expenses
327
Depreciation
90
Operating income
190
29
Other income
Earnings before interest and taxes
219
Interest expense
49
Pretax income
170
Taxes
84
Current 71
Deferred 13
Net income
86
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U.S.C.C. Income Statement
Total operating revenues
2,262
Cost of goods sold
1,655
Selling, general, and administrative expenses
327
Depreciation
90
Operating income
190
Other income
29
Earnings before interest and taxes
219
Usually a separate section reports the amount of
taxes levied on income.
Interest expense
49
Pretax income
170
Taxes
84
Current 71
Deferred 13
Net income
86
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U.S.C.C. Income Statement
Total operating revenues
2,262
Cost of goods sold
1,655
Selling, general, and administrative expenses
327
Depreciation
90
Operating income
190
Other income
29
Earnings before interest and taxes
219
Interest expense
49
Net income is the bottom line.
Pretax income
170
Taxes
84
Current 71
Deferred 13
Net income
86
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Income Statement Analysis

• There are three things to keep in mind when
  analyzing an income statement
• Generally Accepted Accounting Principles (GAAP)
• Non-Cash Items
• Time and Costs

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GAAP

• The matching principal of GAAP dictates that
  revenues be matched with expenses.
• Thus, income is reported when it is earned, even
  though no cash flow may have occurred.

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Non-Cash Items

• The income statements also makes allowances for
  expense where no money changes hands
• Depreciation is the most apparent example. No
  firm ever writes a check for depreciation.
• Another non-cash item is deferred taxes, which
  does not represent a cash flow.
• Thus, net income is not cash.

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Time and Costs

• In the short-run, certain equipment, resources,
  and commitments of the firm are fixed, but the
  firm can vary such inputs as labor and raw
  materials.
• In the long-run, all inputs of production (and
  hence costs) are variable.
• Financial accountants do not distinguish between
  variable costs and fixed costs. Instead,
  accounting costs usually fit into a
  classification that distinguishes product costs
  from period costs.

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Taxes

• In this world nothing is certain but death and
  taxes. Ben Franklin
• Taxes represent a major cost to the firm
• Taxes rules change, and are subject to political,
  not economic forces
• What this means is that taxes do not need to make
  economic sense
• Company is subject to two different tax rates
• Marginal the percentage paid on the next dollar
  earned
• Average the tax bill / taxable income

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Marginal versus Average Rates

• Suppose your firm earns 4 million in taxable
  income.
• What is the firms tax liability?
• .15(50,000) .25(75,000 50,000) .34(100,000
  75,000) .39(335,000 100,000)
  .34(4,000,000 335,000) 1,356,100
• Rate from table 2.3
• What is the average tax rate?
• What is the marginal tax rate?
• If you are considering a project that will
  increase the firms taxable income by 1 million,
  what tax rate should you use in your analysis?

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Net Working Capital

• Net Working Capital (NWC)
• Current Assets Current Liabilities
• NWC is usually positive for a growing firm
• Why?

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U.S.C.C. Balance Sheet
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Financial Cash Flow

• As finance people what we are really interested
  in is the firms actual cash flow
• Since there is no magic in finance, it must be
  the case that the cash flow received from the
  firms assets must equal the cash flows to the
  firms creditors and stockholders.
• CF(A) CF(B) CF(S)

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U.S.C.C. Financial Cash Flow
Cash Flow from Assets
Cash Flow to Investors
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The Cash Flow Statement

• The Cash Flow Statement is used by firms to
  explain changes in their cash balances over a
  period of time by identifying all of the sources
  and uses of cash for the period spanned by the
  statement.

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The Statement of Cash Flows

• The three components are
• Cash flow from operating activities
• Cash flow from investing activities
• Cash flow from financing activities

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U.S.C.C. Cash Flow from Operations
Idea Translate Net Income into cash
To calculate cash flow from operations, start
with net income, then add back non-cash items
like depreciation and adjust for changes in
current assets and liabilities (other than cash).
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U.S.C.C. Cash Flow from Investing
Cash flow from investing activities involves
changes in capital assets acquisition of fixed
assets and sales of fixed assets (i.e., net
capital expenditures). The cash from sales of
our buildings/machinery minus the cost of
buildings/machinery we bought
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U.S.C.C. Cash Flow from Financing
Cash flows to and from creditors and owners
include changes in equity and debt.
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U.S.C.C. Statement of Cash Flows
The statement of cash flows is the addition of
cash flows from operations, investing, and
financing.
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Quick Quiz

1. What is the difference between book value and
   market value? Which should we use for decision
   making purposes?
2. What is the difference between accounting income
   and cash flow? Which do we need to use when
   making decisions?
3. What is the difference between average and
   marginal tax rates? Which should we use when
   making financial decisions?
4. How do we determine a firms cash flows? What are
   the equations, and where do we find the
   information?

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Financial Statements Analysis and Long-Term
Planning
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Financial Statements Analysis

• Common-Size Balance Sheets
• Compute all accounts as a percent of total assets
• Common-Size Income Statements
• Compute all line items as a percent of sales
• Standardized statements make it easier to compare
  financial information, particularly as the
  company grows.
• They are also useful for comparing companies of
  different sizes, particularly within the same
  industry.

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Ratio Analysis

• Ratios allow for a better comparison through time
  and/or between companies
• Give a sense for how the firm is doing
• As we look at each ratio, ask yourself
• How is the ratio computed?
• What is the ratio trying to measure and why?
• What is the unit of measurement?
• What does the value indicate?
• How can we improve the companys ratio?

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Categories of Financial Ratios

• Short-term solvency, or liquidity ratios
• Long-term solvency, or financial leverage ratios
• Asset management, or turnover ratios
• Profitability ratios
• Market value ratios

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Liquidity Ratios

• These measure the ability of the firm to meet
  its short term obligations
• Why is this important?
• Current Ratio CA / CL
• 708 / 540 1.31 times
• Quick Ratio (Acid Test) (CA Inventory) / CL
• (708 - 422) / 540 0.53 times
• Cash Ratio Cash / CL
• 98 / 540 0.18 times
• Where do the raw numbers come from?

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Leverage Ratios

• These measure the ability of the firm to meet
  its long term obligations
• Why is this important?
• Total Debt Ratio (TA TE) / TA
• (3588 - 2591) / 3588 28
• Debt/Equity TD / TE
• (3588 2591) / 2591 38.5
• Equity Multiplier TA / TE 1 D/E
• 1 .385 1.385
• Where do the raw numbers come from?

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Coverage Ratios

• These measure the ability of the firm to pay its
  debt holders
• Why do we care about paying the debt holders?
• Times Interest Earned EBIT / Interest
• 691 / 141 4.9 times
• Cash Coverage (EBIT Depreciation) / Interest
• (691 276) / 141 6.9 times
• Where do the raw numbers come from?

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Inventory Ratios

• These tell else how efficiently the firm manages
  its inventory
• Why do we care about this?
• Do we want these ratios to be high or low?
• Where do the raw numbers come from?
• Inventory Turnover Cost of Goods Sold /
  Inventory
• 1344 / 422 3.2 times
• Days Sales in Inventory 365 / Inventory
  Turnover
• 365 / 3.2 114 days

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Receivables Ratios

• These tell else how quickly the firm is paid?
• Why do we care about this?
• Do we want these ratios to be high or low?
• Where do the raw numbers come from?
• Receivables Turnover Sales / Accounts
  Receivable
• 2311 / 188 12.3 times
• Days Sales in Receivables 365 / Receivables
  Turnover
• 365 / 12.3 30 days

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Total Asset Turnover

• This tells us how efficiently the firm is turning
  assets into sales
• Why do we care about this?
• Total Asset Turnover Sales / Total Assets
• 2311 / 3588 0.64 times
• It is not unusual for TAT lt 1, especially if a
  firm has a large amount of fixed assets.

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Profitability Measures

• These measure how efficiently the firm operates
• Why do we care about these?
• Where do the raw numbers come from?
• Profit Margin Net Income / Sales
• 363 / 2311 15.7
• Return on Assets (ROA) Net Income / Total
  Assets
• 363 / 3588 10.1
• Return on Equity (ROE) Net Income / Total
  Equity
• 363 / 2591 14.0

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Market Value Measures

• These tell us how the market (people) feel about
  the firm
• Where do these raw numbers come from?
• Market Price 88 per share
• Shares outstanding 33 million
• PE Ratio Price per share / Earnings per share
• 88 / 11 8 times
• Market-to-book ratio market value per share /
  book value per share
• 88 / (2591 / 33) 1.12 times

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The Du Pont Identity

• Created by Du Pont in 1920
• Breaking ROE (NI/TE)into three parts, so we can
  understand where our return comes from
• ROE PM TAT EM
• Calculation
• ROE (NI / TE) (TA / TA)
• ROE (NI / TA) (TA / TE) ROA EM
• ROE (NI / TA) (TA / TE) (Sales / Sales)
• ROE (NI / Sales) (Sales / TA) (TA / TE)

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What does it mean?

• ROE PM TAT EM
• Profit margin is a measure of the firms
  operating efficiency how well it controls
  costs.
• Total asset turnover is a measure of the firms
  asset use efficiency how well it manages its
  assets.
• Equity multiplier is a measure of the firms
  financial leverage.

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Using Financial Statements

• Ratios are not very helpful by themselves they
  need to be compared to something
• Time-Trend Analysis
• Used to see how the firms performance is
  changing through time
• Peer Group Analysis
• Compare to similar companies or within industries
• SIC and NAICS codes

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Potential Problems to Remember when Analyzing
Financial Statement

• There is no underlying theory, so there is no
  definitive way to know which ratios are most
  relevant
• Benchmarking is difficult
• Especially for diversified firms
• Firms use varying accounting procedures
• Ex. LIFO versus FIFO
• Globalization means different accounting
  regulations
• Firms have different fiscal years
• Extraordinary, or one-time, events

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Financing Growth

• When growth is slow, the firm may be able to rely
  on internal financing
• Just using what they make
• At higher growth rates, the firm will likely need
  to go to the capital market for additional
  financing

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The Internal Growth Rate

• The internal growth using the funds it generates
• The Internal Growth Rate can be calculated with
  ROA and Plowback
• Plowback ratio how much of net income is being
  reinvested in the company
• b Addition to Retained Earnings / Net Income
• IGR (ROA b)/(1-ROA b)

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IGR Calculation

• If a firm has an ROA of 0.132, and a plowback
  ratio of 0.667, what is its IGR?
• IGR (ROA b )/ (1 ROA b)

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The Sustainable Growth Rate

• The sustainable growth rate tells us how fast the
  firm can grow by using internally generated funds
  and issuing debt, without changing the firms
  capital structure
• Do you expect this be higher or lower than the
  internal growth rate?
• The Sustainable Growth Rate is calculated with
  ROE and Plowback
• Just like IGR but use ROE instead of ROA

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SGR Calculation

• If the same firm has an ROE of 0.264, what is its
  SGR? Remember plowback is 0.667
• (ROE b )/ (1 ROE b)

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Quick Quiz

1. How do you standardize balance sheets and income
   statements?
2. Why is standardization useful?
3. What are the major categories of financial
   ratios?
4. How do you compute the ratios within each
   category?
5. What are some of the problems associated with
   financial statement analysis?

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Quick Quiz

1. What is the purpose of long-range planning?
2. What are the major decision areas involved in
   developing a plan?
3. What is the percentage of sales approach?
4. What is the internal growth rate?
5. What is the sustainable growth rate?
6. What are the major determinants of growth?