BA 3341 Business Finance Nataliya Polkovnichenko, Senior Lecturer

Class Notes: Set 1

Brief Overview of Finance Basics

Outline
Forms of Business Organizations The Finance Model of the Firm The Role of the Financial Manager Goal of the Corporation Agency Problems Financial Markets and the Corporation
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Types of Business Organizations

In terms of organization, businesses falls into the following four categories: Sole Proprietorships Partnerships Corporations Hybrid forms (of the above basic 3 types) They differ in their ownership, taxation form and the liability limitation.
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Sole Proprietorships
Manager is the sole owner; bears all the costs and keeps all the profits after taxes Personal liability for the business activity is unlimited Firm profit is taxed only once

Partnerships
Several entrepreneurs come together to set up a business, by pooling money and expertise A partnership agreement sets out how management decisions are taken, profits are shared etc. Unlimited personal liability Firm profit is taxed only once
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Corporation
A legal entity separate from its owners (shareholders) Limited liability for the business activity from its owners Firm profit is double taxed

Double Taxation Of Corporate Profit

Dividends=$0.65

Corporation

Corporate Profit= $1 35%

Corporate Tax=$0.35

25%

Personal Income Tax=$0.16

Corporation Owners

Corporate Structure
Sole Proprietorships
Unlimited liability Personal tax on profits

Partnerships

Corporations

Limited liability Corporate tax on profits + Personal tax on dividends

Hybrid forms
Combine the features of the above 3 basic types. Some examples are: Limited Partnership (LP): An LP has both limited liability partners and at least, one unlimited liability partner. Limited Liability Partnership (LLP): All partners have limited liability, but partners are taxed as partners, avoiding double taxation. Professional Corporation (PC): Used by professionals; has limited liability for owners except in the area of malpractice.

Why do Corporations Dominate the Business Landscape?

Limited Liability
Shareholders avoid risk beyond investment. Encourages risk taking behavior.

Continuity
Outlasts the individual owners. Ownership can be easily transferred.

Easier to raise external funds

Large projects can be undertaken. Growth can be supported.

Most of this course will focus on finance as practiced in corporations.

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Questions
What form would you expect the following businesses to use?
Shoe repair shop Bar or Restaurant Steel Manufacturing Firm Computer Consulting Firm Multinational Consumer Electronics Firm
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Business Organizations
Sole Proprietorship Who owns the business? Are managers and owners separate? What is the owners liability? Are owners& the business taxed separately? The Manager

Partnership

Corporation

Partners

Shareholders

No

No

Usually

Unlimited

Unlimited

Limited

No

No

Yes
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The Finance Model of the Firm

Firms apply real assets through operations to provide products and services. Investment decision: determining which real assets the firm should acquire.
In Finance we refer to the evaluation of alternative investment decisions as the capital budgeting decision.

Financing decision: raising money to acquire real assets.

In Finance we refer to the mix of long term financing decisions made by a firm as the capital structure decision.

Managing working capital

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Real Assets & Financial Assets

Real Assets Tangible Real Assets Inventory and Supplies Plant & Machinery Offices & Equipment Intangible Real Assets Technical Expertise Patents Trademarks Financial Assets Bank Loans Bonds Shares of Stock Other Securities

Selecting among & acquiring real assets is capital budgeting

Selecting among sources & raising funds for the purchase of real assets is the financing decision

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Investment decision=

capital budgeting decision

Financing decision= capital structure decision.
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Questions
Are the following capital budgeting or financing decisions?
Determining how much to spend on a new computer Issuing shares of stock to finance the construction of a new manufacturing plant Buying the rights to use NFL logos on clothing Borrowing money from the bank to repurchase shares of stock on the secondary market
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Who makes those decisions?

Financial Manager

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Who is the Financial Manager?

Financial manager: responsible for a significant corporate investment or financing decision. The financial managers in large corporations: Chief Financial Officer (CFO): financial policy, corporate planning Treasurer: cash management, raising capital, banking relationships Controller: preparation of financial statement, accounting, taxes
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The role of the financial manager

The financial manager stands between the firms real assets and the financial markets. They have two decisions to make: Capital Budgeting Decision Financing Decision Note: because of the importance of many financial issues, ultimate decisions often rest by law or by custom with the board of directors.
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The role of the financial manager

Firms Operations

1
4a 4b Financial Markets

1. Cash raised from investors 2. Cash invested in firm

3. Cash generated by operations

4a. Cash reinvested 4b. Cash returned to investors
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Goal of the Firm

To Maximize Shareholder Wealth

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Maximizing Shareholder Wealth versus Other Objectives

Maximizing Accounting Profits Maximizing Market Share Maximizing Revenue Minimizing Expenses
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The Agency Problem

The agency relationship Managers are agents Will managers work in the shareholders best interests?

Agency costs
How do agency costs affect firm value (and shareholder wealth)?
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The Agency Problem

Managers are Agents and may not work in the Shareholders best Interests Direct Agency Costs Corporate Perks Growth that Doesnt Add Value or Empire Building Indirect Agency Costs Risk Avoidance Reduced Effort Entrenchment
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The Agency Problem: Constraining Management Behavior

Agents have considerable freedom to act, but they eventually face the consequences of their actions. Management is constrained by numerous forces.
compensation plans board of directors oversight takeovers specialist (analyst) monitoring Auditors Fraud can be concealed for a while, but eventually these actions are discovered.
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Financial markets and institutions are the firms financial environment.

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Financing for Corporations

Financial Markets Financial Intermediaries (Mutual Funds, Pension Funds, Financial Institutions) Financial Institutions (Banks, Insurance Companies)

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Flow of Investments and Returns

Financial Markets
Firms Operations Real Assets

Financial Manager

Investors

Financial Intermediaries
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Financial Markets
Firms issue debt or equity by selling securities to investors. Primary Market - The initial sale of securities from the Issuer (the firm) to the investor. IPOs and New Debt Issues Seasoned Equity Offerings Secondary Market - The subsequent trading of these securities among investors and intermediaries. Exchange Markets - NYSE, Amex Over-the-counter (OTC) NASDAQ
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Secondary Markets Are Important

Secondary markets establish the value of a firms securities. Understanding how these values are established is obviously important to the Financial Manager. Secondary markets evaluate a firms capital budgeting decisions. Successful capital budgeting decisions increase the value of the firm. Understanding how investors evaluate these decisions is important. 30

What is the main function of financial markets and intermediaries?

They channel savings to real investment!

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Now you should be able to:

Explain the differences between the most common forms of business organization and determine which forms are most suitable to different types of business. Explain why it makes sense for corporations to maximize their market values. Show why conflicts of interest may arise in large organizations and discuss how corporations can provide incentives for everyone to work toward a common goal. Understand how financial markets and institutions channel savings to corporate investment.
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mini

-Quiz

Capital budgeting decisions are used to determine how to raise the cash necessary for investments. Secondary markets establish the value of a firms securities. The primary goal of any company should be to maximize current period profit.
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Next Class
The Time Value Of Money

Read Ch.5
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