Transcript Lecture 1 Basic Finance - Rowdy | Rowdy | MSU Denver

An Overview of Financial
Management
Timothy R. Mayes, Ph.D.
FIN 3300: Chapter 1
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What is Corporate Finance
Corporate finance is really about making
business decisions
 Corporate finance is primarily concerned
with three areas:

• Capital budgeting
• Capital structure
• Working capital management
2
Other Subject Areas of Finance

Aside from corporate finance, there are a
wide variety of topics that are studied by
financial economists:
•
•
•
•

Investments (personal and corporate)
Banking
Insurance
Real estate
These are very broad subject areas that
frequently overlap
3
Some Fundamental Principles

Before we begin to study corporate finance in
detail, there are two fundamental concepts
that must be understood:
• The correct goal of the firm
• The risk/return tradeoff

These two concepts underlie every major
technique that we will study
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The Incorrect Goal of the Firm
Most people have been taught that the goal of
the firm is to maximize current profits
 This goal is inadequate for at least three
reasons:

• It ignores the time value of money
• It ignores risk
• It can lead to a preoccupation with short-term
results which, in turn, can lead to sub-optimal
long-term results
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The Correct Goal of the Firm




The correct goal of the firm is to maximize shareholder
wealth (i.e., shareholder’s equity) or, equivalently, to
maximize the firm’s stock price.
By this we mean to imply that the managers of the
firm work for the shareholders
For this reason, they have a duty to make
investments that are expected to increase shareholder
wealth
Further, they have a duty to take all investments that
are expected to increase shareholder wealth
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The Goal of U.S. West Inc.

From the U.S. West Annual Report to
Shareowners 1988:
Our mission is to provide quality products
and services to customers in responsive and
innovative ways in order to create the highest
possible value for our investors through long-term
growth and profitability
(emphasis added)
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The Agency Problem
Because managers work for the shareholders,
they are considered to be agents for the
shareholders.
 Occasionally, managers may act in their own
best interest, rather than in the interest of
their shareholders
 This is known as an agency problem

8
Agency Costs

There are two types of costs associated with
the agency problem:
• Direct agency costs are the loss in shareholder
wealth due to managerial misconduct
• Indirect agency costs are the costs of avoiding the
agency problem
9
The Risk/Return Tradeoff
Throughout financial theory, we assume that
individuals are risk averse
 This means that individuals prefer less risk to
more risk
 However, a risk averse individual will accept
almost any level of risk as long as they are
properly compensated
 We assume that the risk-return tradeoff is a
linear function (there is no good evidence that
it isn’t)
10

The Risk/Return Tradeoff Graphically



Assume that there are
two projects: A and B
Project B is riskier than
project A
B
Therefore, we expect
A
that B will, on average
over time, earn a higher
return than A
Otherwise, nobody
would ever invest in B
Retur
n

A
B
Risk
11
Legal Forms of Organization
There are several legal forms that an
organization may take
 Each form has advantages and disadvantages
 We will discuss the three major forms:

• Sole proprietorships
• Partnerships
• ‘C’ Corporations
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The Sole Proprietorship


A sole proprietorship is a business that is owned by a
single person
Benefits
• Easy and inexpensive to start

Drawbacks
• Unlimited liability
• Life of business limited to life of owner
• Difficult to raise funds
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The General Partnership



A general partnership is similar to a proprietorship,
but more than one person owns it
Advantages
• Fairly easy to start up
• Income taxed as personal income
Disadvantages
• Life of partnership limited to life of partners
• Unlimited “joint and several” liability
• Difficult to transfer the business
14
The Limited Partnership

Limited partnerships are similar to general
partnerships, but there are two kinds of
partners:
• Limited partners are investors only. They have
limited liability, but they are not allowed to
participate in the day to day operation of the
business
• General partners have unlimited liability, but
they also have operational control of the business
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The ‘C’ Corporation



A corporation is a legally created being with most of
the rights and duties of ordinary citizens
Advantages
• Owners have limited liability
• Ownership is easily transferred
Disadvantages
• Relatively difficult and expensive to start up
• Double taxation of income
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The Income Statement


The income statement
provides a summary of
the revenues and
expenses of a company
during an accounting
period
Income statements may
be compiled for any
period of time (annual,
quarter, month, etc.)
Elvis Products International
Income Statement
For the Year Ended Dec. 31, 1997 ($ 000's)
Sales
Cost of Goods Sold
Gross Profit
Selling and G&A Expenses
Fixed Expenses
Depreciation Expense
EBIT
Interest Expense
Earnings Before Taxes
Taxes @ 40%
Net Income
1997
3900.00
3250.00
650.00
330.30
100.00
20.00
199.70
76.00
123.70
49.48
74.22
1996
3500.00
2864.00
636.00
240.00
100.00
18.90
277.10
62.50
214.60
85.84
128.76
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Important Notes about the IS
The income statement includes only revenues
and expenses
 These revenues and expenses are for a
particular period of time and are not
cumulative
 Depreciation is a non-cash expense
 Dividends paid to stockholders are not
deductible, but 30%of dividends received are
counted as taxable income

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Depreciation and Cash Flow



Depreciation is a non-cash expense that is subtracted from
revenues when calculating net income
Because of depreciation, net income does not represent
the funds that a firm has available for expansion or
paying dividends
Instead of net income, financial analysts are generally
concerned with cash flow:
• Cash Flow = Net Income + Non-Cash Expenses
• Operating Cash Flow = EBIT + Non-Cash Exp - Taxes
19
The Balance Sheet
Elvis Products International
Balance Sheet
As of Dec. 31, 1997 ($ 000's)




The balance sheet shows AssetsCash and Equivalents
Accounts Receivable
the amount of assets,
Inventory
liabilities and equity of a Total Current Assets
Plant & Equipment
firm at a point in time
Accumulated Depreciation
Net Fixed Assets
Assets are the things that Total Assets
Liabilities and Owner's Equity
a firm owns
Accounts Payable
Liabilities are the debts of Short-term Notes Payable
Other Current Liabilities
the firm
Total Current Liabilities
Long-term Debt
Equity is the difference
Total Liabilities
Common Stock
between assets and
Retained Earnings
Total Shareholder's Equity
liabilities
Total Liabilities and Owner's Equity
1997
50.00
402.00
838.00
1290.00
527.00
166.20
1996
57.60
351.20
715.20
1124.00
491.00
146.20
360.80
344.80
1650.80
1468.80
175.20
225.00
140.00
540.20
424.61
964.81
460.00
225.99
685.99
1650.80
145.60
200.00
136.00
481.60
323.43
805.03
460.00
203.77
663.77
1468.80
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Notes on the Balance Sheet


Accumulated depreciation is an accumulation
account
Common equity is made up of:
• Common stock
• Additional paid-in capital
• Retained earnings

Retained earnings is an accumulation account, and
changes each period according to the formula:
 R E  N et In co m e  D iv id en d s
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The Statement of Cash Flows


This statement shows
where a firm’s funds
came from and how
they were used
Three parts:
• Funds from Operations
• Funds from Investing
• Funds from Financing
Elvis Products International
Statement of Cash Flows
For the Year Ended Dec. 31, 1997 (000's)
Cash Flows from Operations
Net Income
Depreciation Expense
Change in Accounts Receivable
Change in Inventories
Change in Accounts Payable
Change in Short-term Notes Payable
Change in Other Current Liabilities
Total Cash Flows from Operations
Cash Flows from Investing
Change in Plant & Equipment
Total Cash Flows from Investing
Cash Flows from Financing
Change in Long-term Debt
Cash Dividends Paid to Shareholders
Total Cash Flows from Financing
Net Change in Cash Balance
74.22
20.00
-50.80
-122.80
29.60
25.00
4.00
-20.78
-36.00
-36.00
101.18
-52.00
49.18
-7.60
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Sources vs. Uses of Funds

Essentially, there are two types of transactions that a
firm engages in:
• Those that increase the cash balance are referred to as sources
of funds
• Those that decrease the cash balance are referred to as uses
of funds
Source
(+)
Use
(-)
Asset
Liability
23
Why Do We Pay Taxes?

There are at least three reasons that we pay
taxes:
• To raise revenues
• To achieve social objectives
• To manipulate the economy
24
Calculating Corporate Income Taxes
Taxable Income
Between
Tax Rate
0 to 50,000
15%
50,000 to 75,000
25%
More than 75,000
34%
100,000 to 335,000
39%
335,001 to 10,000,000
34%
10,000,001 to 15,000,000
35%
15,000,000 to 18,333,333
38%
18,333,333 +
35%
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Corporate Taxes Graphically
40%
35%
T ax R ate
30%
25%
20%
15%
10%
5%
0%
$0
$5,000,000 $10,000,000 $15,000,000 $20,000,000 $25,000,000
Taxable Income
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Marginal vs. Average Tax Rates

Tax rates are commonly discussed in two
different ways:
• The marginal tax rate is the rate that will be paid on
the next dollar of taxable income
• The average tax rate is the average rate that is paid
on each dollar of taxable income

The marginal tax rate is the rate that is
appropriate to use for decision making
purposes
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Corporate Taxes: Example 1
Tax Rate
Taxable Income
Less: first 50,000
Yet to be taxed
Less: Next 25,000
Yet to be taxed
Less: Next 25,000
Yet to be taxed
Total Tax Liability
Average Tax Rate
Marginal Tax Rate
200,000
50000
150,000
25000
125,000
25000
100,000
Tax
15%
7,500
25%
6,250
34%
39%
8,500
39,000
61,250
30.625%
39.00%
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Corporate Taxes: Example 2
T a x R a te
T ax ab le In co m e
L ess: F irst 5 0 ,0 0 0
Y et to b e tax ed
L ess: N ex t 2 5 ,0 0 0
Y et to b e tax ed
L ess: N ex t 2 5 ,0 0 0
T a x es
4 0 0 ,0 0 0
5 0 ,0 0 0
15%
7 ,5 0 0
25%
6 ,2 5 0
34%
8 ,5 0 0
3 5 0 ,0 0 0
2 5 ,0 0 0
3 2 5 ,0 0 0
2 5 ,0 0 0
Y et to b e tax ed
3 0 0 ,0 0 0
L ess: N ex t 2 3 5 ,0 0 0
2 3 5 ,0 0 0
39%
9 1 ,6 5 0
6 5 ,0 0 0
34%
2 2 ,1 0 0
Y et to b e tax ed
T o tal T ax D u e
1 3 6 ,0 0 0
A v erag e T ax R ate
3 4 .0 0 0 %
M arg in al T ax R ate
34%
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Depreciation
Accountants define depreciation as, “a
systematic method of allocating the cost of an
asset over its useful life.”
 For tax purposes, we aren’t allowed to deduct
the full cost of an asset in the year of
purchase. Instead, we must deduct the cost
over the life of the asset through depreciation
 In finance, we tend to think of depreciation as
a way of reducing taxes

30
Straight-line Depreciation

Straight-line depreciation assumes that the value of
an asset declines equally in each year of its life:
A n n u al S L D ep 
C o st  S alv ag e
U sefu l L ife
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MACRS Depreciation
Generally speaking, we prefer to receive cash
flows sooner rather than later
 Ideally, we would like to be able to deduct
the full cost of an asset at the time of purchase
 However, except for small assets, this is not
allowed
 The IRS does allow accelerated depreciation
which is an improvement over straight-line
because it allows quicker tax savings

32
A Note on the Focus of this Class
Throughout this class we assume that the
firm’s we discuss are corporations
 However, most of the concepts that we
discuss are relevant to all organizational
forms
 Many (if not all) of the concepts are even
relevant to your personal life

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