Chapter 1

Foundations

Slides developed by:

Pamela L. Hall, Western Washington University
Main Areas of Finance
 Investments and financial markets
 Financial management of corporations
 Fields are separate but related

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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
income
 Stock—ownership interest in a company
• Entitled to a share of the firm’s profits, either dividends or future
growth
 Bond—debt interest in a company
• Entitled to interest and repayment of principal
 Investing involves buying financial assets in the hope of
earning a return
 Can be made directly or indirectly (buying shares in a mutual
fund)

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Financial Markets
 Financial Market
 Financial assets are issued by corporations
and bought by investors in financial markets
• A framework or organization in which people can
buy/sell securities
• Stock market (NYSE, AMEX, OTC)--entire network of brokers
and exchanges all connected together
• Stockbroker (broker)--person who is licensed to trade
securities for a commission

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Financial Markets
 Secondary market—place where investors trade
securities among themselves (NYSE, etc.)
 Most transactions are of this type
 Primary market—market where securities are
initially sold (I.P.O.)
 Investments
 Making decisions about buying and selling stock and
bonds
 Financial management
 Decisions about raising money and how to spend it

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Figure 1.1: Simplified Financial
System

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Raising Money
 Financing means raising money to acquire
something
 Forms of Financing
 Issuing stock (equity financing)
 Borrowing money (debt financing)
• Bank
• Issuing bonds
• Leasing
 Internal financing (retaining earnings)
• Still considered equity financing

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Raising Money
 Field of finance includes raising money
and investing money
 Changing Focus of Finance
 Finance used to be narrowly limited to
financial market activity
 However has expanded to include
• Portfolio formation and analysis
• A portfolio is a collection of securities
• Financial management within an organization

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Financial Management
 Financial Management is the management and
control of money and money-related operations
within a business
 Executive in charge of finance department
 CFO: Chief Financial Officer (AKA: VP of Finance)
• Typically reports directly to the President of the corporation

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Financial Management
 Refers to the functions of the finance
department
 Keeping records
 Receiving payments from customers
 Making payments to suppliers
 Borrowing funds Accounting
 Purchasing assets department is
 Selling stock included in the
 Paying dividends, etc. broad definition
of finance.

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Financial Management
 Business Decisions
 Finance department is in charge of:
• Determining which assets a firm should purchase
• Acquiring another firm
• Expanding operations
• A different product line
• Current operations expanding to another country
• Deciding how those assets will be financed
• Equity
• Debt
• Loan via bank
• Bond issue

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Financial Management
 Oversight
 Finance department must also perform an
oversight function
• Looking over everyone’s shoulder to make certain
money is being used effectively
• For example,
• Are manufacturing costs too high?
• Are advertising costs too high?

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The Price of Securities—A Link
Between the Firm and the Market
 Investors buy securities for the future cash flows
expected from them
 Price investors are willing to pay depends on
expectations of how well the companies are likely to
do
 Link between company management and
investors comes from this relationship between
price and expected financial results
 Everything firm does is evaluated by market and
‘graded’ by either an , , or no change in security
price

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The Price of Securities—A Link
Between the Firm and the Market
 Does management care what ‘grade’ it
receives?
 YES! Why?
• Management will need to issue new securities in
the future (to raise $) and therefore want a high
security price
• Stockholders own the firm and if the stock price
declines shareholders will be disgruntled

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Finance and Accounting
 Accounting: a 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: a process of decision-making related
to raising money, analyzing results, etc.
 Use the output generated by accountants as inputs
in finance

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Finance and Accounting
 Finance department generally consists of both
the accounting department and the treasury
department
 Controller is in charge of the accounting department
 Treasury department deals with finance activities
 Crossover is possible
 Usually easier for an accountant to move to the
treasury department

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Figure 1.2: Finance
Department Organization

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The Importance of Cash Flow
 Accounting attempts to reflect a firm’s
financial results in a way that represents
what is physically occurring
 Finance is interested in how cash is
flowing (or expected to flow)
 We need a cash amount because we’ll be
looking at returns on money invested, and
you can’t invest a non-cash number
• Cash is King

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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.
Example

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.

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The Language of Finance
 Accounting is the language of finance
 Thus all finance professionals need some
accounting knowledge
• Level of accounting knowledge needed depends
on job
• Financial analyst needs to know LOTS of accounting because
s/he investigates companies and makes recommendations
concerning their value in market (must decipher complex
financial statements as part of that process)
• Stockbrokers do not need as thorough an understanding
because they generally trade securities based on the financial
analyst’s recommendation

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Financial Theory—The
Relationship with Economics
 Financial theory developed from
economics
 Modern financial theory began as a branch of
economics in the 1950s
• Today finance is viewed as a separate field
 Scholars in both fields make observations
between business world and government
and attempt to model the behavior

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Figure 1.3: The Influence of Accounting,
Economics and Financial Theory on
Financial Management

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Forms of Business Organization
and Their Financial Impact
 Businesses can be legally or organized as
 A sole proprietorship
 A partnership
 A corporation
 Legal organization has an impact on
 Raising money
 Taxation
 Financial liability
 Issues really only important regarding small businesses
 Virtually all large corporations are organized as C-type
organizations

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The Proprietorship Form
 Getting started
 Easy to do
 Taxes
 Profit is taxed as personal income to the business owner
• Are taxed only once
• Taxed at personal income tax rates
 Raising money
 If entrepreneur decides to go outside the firm to raise money,
s/he can obtain a loan
• Lending money is risky
• Best possible outcome: repayment of principal and interest
• Worst possible outcome: lose everything
• Thus, most lenders require collateral
• Many entrepreneurs use their house as collateral

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The Corporate Form
 Getting started
 Requires a legal incorporation process
• Takes time, work and money
 Taxes
 When business makes a profit taxes are paid twice
• The corporation pays a tax at the corporate tax rate
• Dividends paid to individuals are taxed at an individual’s
personal tax rate

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The Corporate Form—Example
Q: Hazel Gilroy owns a business that earns $100,000 before taxes.
She wants to take the earnings home and spend them on
herself. Assume a simplified tax system in which the relevant
rates are 34% for corporations and 30% for individuals on the
entire amounts subject to those taxes. Compare the total tax
bills under the sole proprietorship and corporate forms of
Example

organization.

A: Under the corporate form the $100,000 is first subject to a 34%

corporate tax of $34,000, leaving earnings of $66,000. If Hazel
were to take these earnings she would have to declare them as
a dividend and pay personal taxes at 30%, or $19,800. In a
sole proprietorship the $100,000 is taxed only once at the
personal rate of 30%, for a total tax bill of $30,000. The
difference in taxes of $23,800 is significant.

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The Corporate Form
 Raising Money
 Money for a corporation can be raised by
• Borrowing
• A corporation faces the same issues as a sole proprietorship
when raising money
• Offering stock to investors
• If less than a 50% interest is sold, original owner still maintains
effective control
• Owning stock is risky
• Best possible outcome: may get rich
• Worst possible outcome: may lose all of your investment

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The Truth About Limited
Liability
 Limited liability states that a stockholder is not
liable for a corporation’s debts
 Implies that the most stockholder can lose is 100% of
his investment in the stock
 In a sole proprietorship, the business owner
stands to lose his personal property if all the
assets of the business are insufficient to cover
all liabilities
 Personal guarantees make entrepreneurs liable for
loans made to their business
• Destroys the value of limited liability

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S-Type Corporations
 Major financial advantage of corporate form
 Ability to raise money by issuing stock
 Major financial disadvantage
 Double taxation of earnings
 Government encourages formation of small
businesses because they create numerous jobs
 Government allows creation of S-type corporation
• Lets small businesses avoid double taxation
• Offers limited liability
• Offers ability to sell stock to raise money

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Goals of Management
 Economics—goal is to maximize profit
 But what about R&D?
• If you eliminate R&D you’ll increase short-term profit and
hurt long-term profit
 Finance—Stockholders own the company so the
goal is to maximize their wealth, generally by
maximizing the stock price
 This goal bypasses the concern of whether the short-
term or long-term is more important, because stock
price incorporates both!
• If R&D were eliminated the stock price would not rise, but
rather, drop

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Stakeholders and Conflicts of
Interest
 Constituencies of the company who have a
vested interest in the way the firm is operated
and include
 Stockholders
 Employees
 Customers
 Community
 Management
 Creditors
 Suppliers

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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
• This represents a conflict of interest between
stockholders and employees
• Something that benefits one group and takes away from
another

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Management—A Privileged
Stakeholder Group
 Management represents a privileged stakeholder group
 The ownership of a widely held company is very
dispersed so no one has enough control to influence
management
 IBM has almost 2 billion shares outstanding, and over 600,000
shareholders—so no one person has enough control to
influence management
 This allows top management to become entrenched in
positions controlling large amounts of resources
 Management is able to use these resources for their
own benefit

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The Agency Problem
 Management (agent) is controlling resources
owned by stockholders (principal) and may not
make the decisions stockholders want
 The Abuse of Agency
 Privileges and luxuries provided to executives are
called perquisites or ‘perks’
• Example—management compensation
• Management receives exorbitant salaries/bonuses ($50+
million) while the company performance is poor
• Additional perks include boats, airplanes, country club
memberships, etc.

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The Agency Problems
 Controlling the agency problem
 Efforts to manage agency problem include
• Monitor management (audits)
• Tie management bonuses to corporate stock
performance via a stock option or to corporate
profit

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Creditors Versus Stockholders—A
Financially Important Conflict of Interest
 A creditor is anyone owed money by a
business including lenders, vendors,
employees, or the government
 Actions taken by the leveraged company
that are riskier than before they borrowed
money place creditors at risk
 Lenders generally put clauses in loan
agreements to prevent this from occurring

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