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

Organizing a Business

Financial managers Firm'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 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 Assets Cash & Securities Receivables Inventories + Fixed Assets Tangible Assets Intangible Assets

The Balance Sheet The Main Balance Sheet Items Current Assets Cash & Securities Receivables Inventories + Fixed Assets Tangible Assets Intangible Assets Current Liabilities Payables Short-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 bilDebt = $4 bil Equity = $6 bil

Market Value vs. Book Value Example (continued) Book Value Balance Sheet Assets = $10 bilDebt = $4 bil Equity = $6 bil Market Value Balance Sheet Assets = $11.5 bilDebt = $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 Statement Pepsico Income Statement (year end 1998) Net Sales 22,348 COGS9,330 Other Expenses 291 Selling, G&A expenses8,912 Depreciation expense 1,234 EBIT2,581 Net interest expense 321 Taxable Income2,260 Income Taxes 270 Net Income1,990

Profits vs. Cash Flows Differences “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 Flows Pepsico Statement of Cash Flows (excerpt - year end 1998) Net Income1,990

The Statement of Cash Flows Pepsico Statement of Cash Flows (excerpt - year end 1998) Net Income1,990 Non-cash expenses Depreciation1,234 Other 382 Changes in working capital A/R=(303) A/P=253 Inv=(284) other=(47) (381) Cash Flow from Operations3,212

The Statement of Cash Flows Pepsico Statement of Cash Flows (excerpt - year end 1998) Net Income1,990 Non-cash expenses Depreciation1,234 Other 382 Changes in working capital A/R=(303) A/P=253 Inv=(284) other=(47) (381) Cash Flow from Operations3,212 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 EBIT100 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 AFirm B EBIT Interest 40 0 Pretax Income Taxes (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 AFirm B Net Income Interest 40 0 Net Cash Flow 79 65

Why the difference? Firm AFirm B Net Income Interest 40 0 Net Cash Flow Interest is not taxed! 40*0.35=14 (which is the difference)