1 An Overview of Financial Management Timothy R. Mayes, Ph.D. FIN 3300: Chapter 1

2 What is Corporate Finance v Corporate finance is really about making business decisions v Corporate finance is primarily concerned with three areas: Capital budgeting Capital structure Working capital management

3 Other Subject Areas of Finance v 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 v These are very broad subject areas that frequently overlap

4 Some Fundamental Principles v 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 v These two concepts underlie every major technique that we will study

5 The Incorrect Goal of the Firm v Most people have been taught that the goal of the firm is to maximize current profits v 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

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

7 The Goal of U.S. West Inc. v 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)

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

9 Agency Costs v 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

10 The Risk/Return Tradeoff v Throughout financial theory, we assume that individuals are risk averse v This means that individuals prefer less risk to more risk v However, a risk averse individual will accept almost any level of risk as long as they are properly compensated v We assume that the risk-return tradeoff is a linear function (there is no good evidence that it isn’t)

11 The Risk/Return Tradeoff Graphically v Assume that there are two projects: A and B v Project B is riskier than project A v Therefore, we expect that B will, on average over time, earn a higher return than A v Otherwise, nobody would ever invest in B Risk Retur n BA A B

12 Legal Forms of Organization v There are several legal forms that an organization may take v Each form has advantages and disadvantages v We will discuss the three major forms: Sole proprietorships Partnerships ‘C’ Corporations

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

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

15 The Limited Partnership v 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

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

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

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

19 Depreciation and Cash Flow v Depreciation is a non-cash expense that is subtracted from revenues when calculating net income v Because of depreciation, net income does not represent the funds that a firm has available for expansion or paying dividends v 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

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

21 Notes on the Balance Sheet v Accumulated depreciation is an accumulation account v Common equity is made up of: Common stock Additional paid-in capital Retained earnings v Retained earnings is an accumulation account, and changes each period according to the formula:

22 The Statement of Cash Flows v This statement shows where a firm’s funds came from and how they were used v Three parts: Funds from Operations Funds from Investing Funds from Financing

23 Sources vs. Uses of Funds v 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

24 Why Do We Pay Taxes? v There are at least three reasons that we pay taxes: To raise revenues To achieve social objectives To manipulate the economy

25 Calculating Corporate Income Taxes

26 Corporate Taxes Graphically

27 Marginal vs. Average Tax Rates v 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 v The marginal tax rate is the rate that is appropriate to use for decision making purposes

28 Corporate Taxes: Example 1

29 Corporate Taxes: Example 2

30 Depreciation v Accountants define depreciation as, “a systematic method of allocating the cost of an asset over its useful life.” v For tax purposes, we aren’t 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 v In finance, we tend to think of depreciation as a way of reducing taxes

31 Straight-line Depreciation v Straight-line depreciation assumes that the value of an asset declines equally in each year of its life:

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

33 A Note on the Focus of this Class v Throughout this class we assume that the firm’s we discuss are corporations v However, most of the concepts that we discuss are relevant to all organizational forms v Many (if not all) of the concepts are even relevant to your personal life