Introduction to Financial Management
Finance 5th Edition
Cornett, Adair, and Nofsinger
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Finance in Business and in Life
Money flows from individuals who want to improve their financial future to businesses that want to expand the scale or scope of their operations
These financial exchanges lead to
A more productive economy
The growth of individuals wealth
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Economic Participants
Two dimensions
Participants with extra investment money
Participants with economically viable ideas
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Economic Participants Type 1
Type 1 participants
Do not lend significant sums of money or spend much in business context
No direct role in financial markets
Play an indirect role by providing labor to economic enterprises or by consuming their products
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Economic Participants Type 4
Type 4 participants
Use financial tools to evaluate their own business concepts and then choose the ideas with the most potential
Self-funded, so have no need for financial markets
Financial tools used and types of decisions made are narrowly focused to their own purposes
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Economic Participants Types 2 and 3
Types 2 and 3 participants
Use financial institutions and financial markets for mutually beneficial exchange
Type 2 participants make temporary loans to type 3 participants, who put that money to use with their good business ideas
Usually individual investors
Type 3 participants are idea generators, typically companies with research and development (R&D) departments
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Where Does the Cash Go?
Economically successful projects repay money (plus profit) to investors
Sources of friction arise, thereby reducing the amount of capital returned to investors
Retained earnings are funds the firm keeps for its ongoing operations
Taxes are imposed on corporations and individuals by the government to help fund public services
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Subareas of Finance
Investments
Subarea of finance that involves methods and techniques for making decisions about the following:
What kinds of securities to own (e.g., bonds or stocks)
Which firms securities to buy
How to pay the investor back in the form that the investor wishes (e.g., the timing and certainty of the promised cash flows)
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Subareas of Finance (continued)
Financial management
Subarea of finance that deals with a firms decisions in acquiring and using the cash that is received from investors or from retained earnings
How to organize the firm in a manner that will attract capital
How to raise capital (e.g., bonds versus stocks)
How to minimize taxation
Which projects to fund
How to pay back capital providers
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Subareas of Finance (concluded)
Financial institutions and markets
Facilitate flow of capital between investors and companies
International finance
The use of financial theory in a global business environment
Decisions are complicated by the uncertainty about future exchange rates, political risk, and changing business laws across the globe
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Application and Theory
Risk
Uncertainty of future cash flows due to timing and size
Financial asset
Something worth money, such as a stock or bond
Should depend on the cash flows you expect to receive from that asset in the future
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Application and Theory (continued)
Real assets
Physical property like gold, machinery, equipment, or real estate
Real markets
Places/processes that facilitate the trading of real assets
Time value of money (TVM)
Theory and application of valuing cash flows at various points in time
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Finance vs. Accounting
Accounting
Tracks what happened to firms money in the past
Financial management
Combines historical figures and current information
Determines what should happen with firms money now and in the future
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The Financial Manager
Chief Financial Officer
Highest level financial officer
Controller
Oversees accounting function
Treasurer
Responsible for managing cash, credit, financing, capital budgeting, and risk management
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Finance in Other Business Functions
CFO and treasurer positions tend to be the most visible finance-related positions
Finance permeates the entire business organization
Provides guidance for both strategic and day-to-day decisions of the firm and collecting information for control and feedback about the firms financial decisions
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Finance in Your Personal Life
Help you make good personal financial decisions
Borrowing money for a new car
Refinancing home mortgage at lower rate
Making credit card or student loan payments
Saving for retirement
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Business Organization
The number of owners is the key to how business structures are classified
Single owners, partners, and corporations operate businesses
Advantages and disadvantages related to
Controls and ownership of firm
Owners risks
Access to capital and tax ramifications
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Organizational Forms of Business
Sole Proprietorships
General Partnerships
Corporations
Hybrids
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Sole Proprietorships
Most common type of business in the U.S.
Advantages
Easy to start
Light regulatory and paperwork burden
Owner receives all the firms profits and is solely responsible for all losses
Disadvantages
Unlimited liability
Limited access to capital
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General Partnerships
Partners own the business together
Advantages
Relatively easy to start
Profits are added to each partners personal income and taxed at personal income tax rates
Disadvantages
Partners jointly share unlimited liability
Personally liable for legal actions and debts of firm
Partners may need to give up some ownership and control in the firm to raise more equity capital
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Public Corporations
Legally independent entity entirely separate from its owners
Advantages
Limited liability for owners
Can raise large amounts of capital
Easy to transfer ownership
Disadvantages
Double taxation (corporate level and personal level)
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Hybrid Organizations
Combine some attributes of corporations and some of proprietorships/partnerships
Advantages
Offer single taxation and limited liability to all owners
S Corporations
Limited Liability Partnerships (LLPs)
Limited Liability Companies (LLCs)
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Firm Goals
Owners perspective says the appropriate goal is to maximize shareholder wealth
Stakeholders perspective emphasizes social responsibility over profitability
Managers must maximize total satisfaction of all stakeholders in a business (e.g., owners, shareholders, customers, employees, etc.)
Practitioners and academics believe primary responsibility is to maximize shareholder wealth
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Corporate Goals
Maximize value of owners equity
Increase current value per share (stock price) of existing shares
Common alternatives to maximizing the value of owners equity
Maximize net income or profit
Minimize costs
Maximize market share
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Agency Problem
Stockholders hire managers to run the company, but managers may be tempted to act in their own best interests
The agency problem states that problems arise when a principal (shareholder) hires an agent (manager) and cannot carefully monitor the agents actions
Managers interest may not be aligned with shareholder goals
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Agency Problem (continued)
Three approaches to minimizing this conflict of interest
Ignore it
Research suggests allowing the manager a certain amount of perks might enhance owner value because it may boost managers productivity
Monitor managers actions
Make the managers owners
E.g., award options on the firms stock, allow purchase through an ESPO, etc.
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Corporate Governance Defined
The process of monitoring managers and aligning their incentives with shareholder goals is known as corporate governance
Corporate governance involves the set of laws, policies, incentives, and monitors designed to handle the issues arising from the separation of ownership and control
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Corporate Governance Inside
Inside monitors
Board of Directors
Hires the CEO
Evaluates management
Design compensation contracts to tie managements salaries to firm performance
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Corporate Governance Outside
Outside monitors
Auditors examine the firms accounting systems and comment on whether financial statements fairly represent the firms financial position
Investment analysts follow a firm, conduct their own evaluations, and report to the investment community
Investment banks help firms access capital markets
Credit rating agencies examine a firms financial strength for its debt holders
The government monitors activities via the SEC and the IRS
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Corporate Governance Monitors
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Corporate governance balances the needs of stockholders and managers. Inside the public firm, the members of the board of directors monitor how the firm is run. Outside the firm, auditors, analysts, investment banks, and credit rating agencies act as monitors.
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Ethics
Financial professionals manage other peoples money
Corporate managers
Bankers
Investment advisors
Ethical dilemmas of corporate agency relationship
Stealing from firms = stealing from shareholders
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Financial Markets and Intermediaries
Financial markets and financial intermediaries
Facilitate flow of capital from investors to firms and back to investors
Earn very high profits because of specialized expertise and assets
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Financial Institutions Cash Flows
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The unique services and products that financial institutions provide allow them to make money.
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Big Picture Environment
One of the biggest recent factors affecting the business environment in the U.S. is the Tax Cuts and Jobs Act (TCJA) of 2017
Reduces the amount of debt interest that can be deducted from tax bill
Companies are, therefore, likely to use more equity financing and less debt financing in the future
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Tax Cuts and Jobs Act (TCJA) of 2017
Reductions in individual income tax rates
Corporate tax rates reduced
New deduction for pass-through business income
Liberalized asset expensing and depreciation provisions
New limits on business interest deductions
Stricter rules for deducting losses
Reduced or eliminated deductions for business entertainment and some employee fringe benefits
Change to R&D expense deduction
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