Chapter 1 PPT

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1

© 2008 Thomson South
-
Western

Chapter 1


Foundations

2

An Overview of Finance

Investments and financial markets

Financial management of corporations


Fields are separate but related



3

Financial Assets

Real asset

an object that provides a
service, such as a house, car, art, coin…


Financial asset

a document representing
a claim to future income


Stock represents ownership interest


Bond represents a debt relationship


Investing involves buying financial assets in
the hope of earning more money (a return)


Investments can be made directly or
indirectly through a mutual fund


A Security is a financial asset that can be
traded among investors

4

Raising Money

The most common use of the word
finance involves raising money

to
acquire assets

Forms of Financing


Issuing stock

-

equity financing


Borrowing money

-

debt financing


Bank


Issuing bonds


Leasing is like borrowing


Internal financing

-

retaining earnings


5

Raising Money

The field of finance deals with both
raising and investing money, but:

Changing Focus of Finance


Past

-

finance was limited to
financial market activity


Now
-

it includes:


Goals and activities of investors: Portfolios


The financial management of organizations

6

Financial Management

Functions of the finance department:


Keeping records


Receiving payments from customers


Making payments to suppliers


Borrowing funds


Purchasing assets


Selling stock


Paying dividends


Analysis of business decisions


Oversight of other departments

7

Business Decisions

Finance department provides analyses to
:


Determine which assets are purchased


Acquiring another firm


Expanding operations


Decide how those assets are financed


Equity


Debt


Oversight


Finance department oversees how
other departments spend money

8

The Price of Securities

A Link
Between the Firm and the Market

Two sides of finance



investments and
financial management


connected since
firms sell securities to investors in financial
markets


Investors buy securities for the future cash
flows expected from them


Link between company management and
investors

comes from this relationship
between price and expected financial results

9

Finance and Accounting

Accounting


System of record
-
keeping designed to
portray a firm’s
operations in a
fair/unbiased manner



Generate financial
statements which are
provided to the
marketplace

Finance




Process of decision
-
making related to
raising money,
analyzing results



Use the
output

generated by
accountants as
inputs

in finance


10

Finance Department Organization









Figure 1.2

11

The Importance of Cash Flow

Accounting

creates
statements that are
designed to portray
what is physically
occurring in
numbers

Finance
is concerned
with current and
future cash flow


In finance:
Cash is King

12

The Importance of Cash Flow

Q:

Example: In 1999 we purchased a $1,000 asset that will
be depreciated over five years using straight
-
line
depreciation. Explain how that asset will be viewed from
both an accounting and finance viewpoint.


A:

Accounting: The initial cost of the asset of $1,000 will be
reflected on the books as will the $200 annual
depreciation.



Finance: We are interested in the $1,000 cash outflow
and the taxes saved from the depreciation deduction

not
the depreciation itself.

Example

13

The Language of Finance

Accounting is the language of finance



Finance professionals need
some accounting knowledge


Level of accounting knowledge
depends on job


Financial analyst

needs to know LOTS of accounting


Stockbrokers
do not need as much

14

The Truth About

Limited Liability

Limited liability states that a stockholder is not
liable for a corporation’s debts


Implies that the most a stockholder can lose is 100%
of his investment in the stock


True for owners not involved in the business

However, for owner operated small businesses


Personal guarantees make entrepreneurs liable for
loans made to their business


Legal system holds individuals liable for negligence


These destroy the value of limited liability

15

S
-
Type Corporations and LLCs

Major advantage: Treated as
a partnership

with respect to federal income taxes


LLC is replacing S
-
type

Government encourages formation of small
businesses because they create jobs


S
-
type corporations and LLCs


Let small businesses avoid double taxation


Offer limited liability


Offer the ability to sell stock to raise money

16

Goals of Management

Economics

goal is to maximize profit


Runs into short/long run problems


What about R&D?


Finance

goal is to maximize stockholders’
wealth by maximizing stock price


Bypasses the concern of whether the short
-
term or
long
-
term is more important, because stock price
set in the financial market incorporates
both
!


17

Stakeholders and

Conflicts of Interest


Stakeholders that have an interest in the way
the firm is operated include:


Stockholders


Employees


Customers


Community


Management


Creditors


Suppliers

18

Conflicts of Interest

An Illustration

Example: Employees want management to
build an athletic facility on corporate grounds


Benefit

more effective employees (feel better,
happier, therefore more productive)


Cost

will come from profits that belong to
stockholders


Represents a conflict of interest between
stockholders and employees


What if the request was for healthier working
conditions?


19

Creditors Versus Stockholders

A
Financially Important Conflict of Interest

Creditor

-

anyone owed money by a business
including lenders, vendors, employees, or the
government

If actions of the borrowing firm become


riskier than before loan, creditors/lenders


are subject to more risk



But risk taking rewards all go to stockholders

Lenders put clauses in loan agreements to
prevent this