BCOR 2200 Chapter 1

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					 Chapter 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
• Financial Markets and the Corporation

1.1 A Quick Look
Four Basic Areas of Finance
1. Corporate Finance
  A. Capital Budgeting – Undertake a proposed
  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

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

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

3. Financial Institutions
     •     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
     •     This means making sure they don’t blow up
     •     Or at least trying to decrease the likelihood of them
           blowing up

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

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

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
  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…

Corporate Organization – Figure 1.1 page 6

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,
    •   A corporation is a separate entity for tax and liability

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

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…

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

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

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?

• 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
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?
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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