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BCOR 2200 Chapter 1

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					 Chapter 1
Introduction
               1
Chapter 1 Outline:
• A Quick Look
• Business Finance and The Financial Manager
• Forms of Business Organization
• The Goal of Financial Management
• The Agency Problem and Control of the
  Corporation
• Financial Markets and the Corporation



                                               2
1.1 A Quick Look
Four Basic Areas of Finance
1. Corporate Finance
  A. Capital Budgeting – Undertake a proposed
     project?
  B. How do you pay for the project? (Three choices)
  C. Working Capital Management
2. Investments
3. Financial Institutions
4. International Finance
              Lets go over these in more detail 
Four Basic Areas of Finance
1. Corporate Finance
  A. Capital Budgeting – Undertake a proposed project?
     •    You have an idea. Will it make money?
     •    In other words: Will the idea Increase the firm’s value?
          –    How many units can we sell? (Marketing)
          –    How much will it cost to make the units? (Operations)
  B. How do you pay for the project? (Three choices)
     1.   Sell a piece of the company
          •   Sell an Equity stake a.k.a. sell stock
     2.   Borrow the money
          •   Sell Debt securities a.k.a. sell bonds
     3.   Retain Earnings
          •   Keep past profits to finance expansion

                                                                       4
1. Corporate Finance (Continued)
   C. Working Capital Management
     •   Make Sure there is enough cash and inventory on hand.
           Assets        Liabilities & Equity

           Cash               ST Debt

         Inventory               A/P

            A/R               LT Debt

            PPE                Equity


     •   The BLUE ones are Working Capital Accounts
     •   Too Much Cash? Payoff ST Debt (Lower Interest Expense)
     •   Not Enough cash? Borrow More (Increase Interest
         Expense)


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2. Investments
  –       Firms sell securities (stocks and bonds)
  –       Someone buys them
  –       Which ones should you buy?
  –       What are the worth?
      •     This is called Securities Analysis
  – If I hold a bunch of different securities (which is
    called a portfolio), how do the different securities
    combine into portfolios?
      •     This is called Portfolio Analysis



                                                       6
3. Financial Institutions
  Types:
     •     Commercial Banks – Chase, Wells Fargo…
     •     Investment Banks – Goldman Sachs, Morgan Stanley…
     •     Insurance Companies – GEICO, Anthem …
     •     Investment Companies
           o   Mutual funds – Janus, Fidelity…
           o   Hedge Funds – Bridgewater Associates, Fortress
     •     The study of financial institutions relates to risk
           management
     •     This means making sure they don’t blow up
     •     Or at least trying to decrease the likelihood of them
           blowing up


                                                                   7
4. International Finance
  •       More of a specialization than an area of finance
  •       But also must deal with Currency exchange rates
          and a exchange rate risk
      •     You sell your product for Euros but need Dollars to pay
            suppliers, employees, bondholders and shareholders




                                                                  8
Why Study Finance?
• Everything a firm does must be paid for
  – No matter your chosen profession in the business world
    Marketing, Management, Accounting, Systems…
  – You still have to talk to the finance people
  – Why?
  – To get them to pay for your ideas

• Another reason to study finance…
  – You might actually be rich someday
  – In which case it would be beneficial for you to understand investments
  – Understanding investments means understanding corporations and
    corporate finance
  – The securities you will buy are claims on a corporations earnings and
    assets

                                                                         9
1.2 Business Finance and the Financial Manager
• What do corporate financial professionals do?
  1. Decide if a new business venture will be profitable:
     • Both CURRENT business and potential NEW business
     • We already make red pens. Should we make blue pens?
     • We already make pens. Should we make pencils?
     • We already make pens and pencils. Should we deliver them
       to stores (buy our own trucks)?
     • We make and deliver pens and pencils. Should we make
       hotdogs-on-a-stick?
  2. How to pay for new business?
     • Take on New Owners (sell stock) or Borrow (sell bonds)
  3. Manage the everyday financial activities of the firm
     • Called Working Capital Management
     • Collect from customers, pay suppliers, pay expenses…
     • Sell stocks, bonds, commercial paper, borrow from banks…

                                                              10
Corporate Organization – Figure 1.1 page 6




                                             11
1.3 Forms of Business
  1. Sole Proprietorship
    •   Owned by one Person
    •   Pass-through
    •   Unlimited liability
  2. Partnership
    •   General Partnership
    •   Limited Partnership
    •   Also a pass-through
  3. Corporations
    •   Shareholders, Board of Directors, Managers,
        Employees
    •   A corporation is a separate entity for tax and liability
        purposes

                                                                   12
1.4 Goals of Financial Management
First talk about Stakeholders:
  1.   Owners (Stockholders also called Shareholders)
  2.   Debtors (Bond holders, CP holders, banks…)
  3.   Employees
  4.   Suppliers
  5.   Customers
  6.   Community

So what is the goal of financial management?
  • Maximize Shareholder Value (Help the Owners)
       • What about the rest of the stakeholders?
       • Ignore them
       • At least for the purposes of our value decisions

                                                            13
1.5 Agency Problem and Corporate Control
Managers vs. Stockholders:
• Stockholders want to maximize wealth
  – Maximize share price
  – Or maybe maximize income from shares (dividends)
• What do managers want to maximize?
  – Perquisites (perks): jets, cars, apartments…
  – Control: size of their division: assets, employees…




                                                          14
1.5 Agency Problem and Corporate Control (cont.)
• So try to align manager and stockholder incentives:
   1. Bonuses
   2. ESOPs (Employee Stock Ownership Plans)
      • Stock sold to the employees by the company (new shares issued)
      • Has the effect of diluting the existing shareholder’s stake
   3. Stock Options
      • A stock option is the ability to buy company stock two years from now
        (for example) at the current stock price (say $25)
      • The Options will only be valuable if the stock’s price increases in the
        next two years (above $25)
      • Again, shares sold to the employee by the company (dilution)
• Problems with these three:
   – Short term vs. Long term
   – Employees only care about price being high in two years
   – This caused many of the recent accounting scandals

                                                                              15
1.6 Financial Markets
Firms raise money by selling securities:
1. Sell Stocks
   •    Percentage of Ownership - dilution
   •    Stock holders have rights to a percent of profits and assets
   •    After “borrowers” have been paid
   •    Residual claim
2. Sell bonds or other debt instruments (like CP)
   •    Sell Debt or borrowing money
   •    Coupon Bonds or Zero-Coupon Bonds
   •    Paid BEFORE profits are paid to stock holders
   •    Primary claim
Investors value securities based on:
   1.    Expected payments: dividends, coupons, price appreciation
   2.    Risk: Volatility of payments or price, probability of default
   3.    Liquidity: Can’t sell the security  pay less for it

                                                                         16
Securities Markets Increase Liquidity
• Liquidity is the ability to convert an asset to
  cash (sell it)
Two Components of Liquidity:
1. How quickly can I get “full price”?
2. How much do I have to drop the price to get cash right now?


Note:
• The word “Liquidity” can also refer to a company’s
  ability to meet it’s current payment obligations
• Often through short-term borrowing
   – Recall the definition of working capital management
                                                             17
Brokers versus Dealers
• Broker introduces buyer and seller
    – Earns a commission
• Dealer buys the asset from the seller and then sells is to the buyer
    – Earns the “spread”

Consider the liquidity of:
• A used car
    – Sell using a newspaper or internet add
    – Used car Dealer
•   A house
•   1,000 shares of IBM
•   100,000 shares of IBM
•   10% ownership of McGuckin’s

What kind of markets have brokers? What kind have dealers?
                                                                         18
Back to Securities Markets:
Primary Markets
  • The issuing firm sells the stocks or bonds for the first time
    (like new cars)
  • The issuing firm gets the money
  • The transactions are done through an investment bank
  • The transaction is called underwriting
  • Done by an investment banker

Secondary Markets
  • Secondary market transactions involve an owner selling to
    a different owner (like used cars)
     • The issuing firm does NOT get the money
  • The transaction is done through a market
     • Stocks (NYSE, NASDAQ, OTC), Bonds, Currency, Futures, Options…
     • Read about these markets (page 17)

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