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• Financial Management is the overarching subject.

Business Organizations

• There are three types: sole proprietorship, partnership, and corporation.
• The text focuses primarily on corporations.

Sole Proprietorship

• Characterized by ease of formation, no corporate income taxes, limited life, and difficulty in raising capital.

Partnership

• Similar to a sole proprietorship in structure.

Corporation

• A legal entity separate from its owners and managers.
• Corporations have unlimited life, easy transfer of ownership, limited liability, and are subject to double taxation.

Initial Public Offering (IPO)

• An IPO raises cash for the company.
• It allows founders and pre-IPO investors to "harvest" some of their wealth.

Principal vs. Agent

• The principal is the owner or person in charge.
• Incentives are used to influence people (sticks and carrots).

Agency Problem

• Managers may act in their own interest rather than on behalf of the owners (stockholders).
• The objective of firms is to maximize the share price.

Agency Problems and Corporate Governance

• Shareholders elect a board of directors.

Cash Flow Aspects Affecting Investment Value

• Focus is on free cash flow, which represents a flow over a period.
• Key considerations include the amount of expected cash flows (bigger is better), the timing of the cash flow stream (sooner is better), and the risk of the cash flows (less risk is better).

Free Cash Flow (FCF)

• FCF equals sales revenue minus operating costs, operating taxes, and required investments in operating capital.
• FCFs are the cash flows available for distribution to all investors, including stockholders and creditors.

Assets, Liabilities, and Equity

• Using a house as an example.
• V represents the value of assets.
• L represents liabilities, or what is owed.
• E represents equity, or what is left.
• The formula is V = L + E.

Weighted Average Cost of Capital (WACC)

• WACC is what is needed to earn Apple's assets to keep shareholders and creditors happy.
• It is the average rate of return required by all the company's investors.
• WACC is affected by capital structure, interest rates, risk of the firm, and investors' overall attitude towards risk.
• A lower WACC is more desirable.

Providers and Users of Capital

• Households are net savers.
• Non-financial companies are net borrowers.
• Financial companies (e.g., banks) are slightly net borrowers, but almost break even.
• Banks borrow from people who use the banks (account owners).

Economic Conditions Affecting Interest Rates

• Federal Reserve policies are domestic factors.
• Budget deficits/surpluses are domestic factors.
• The level of business activity, such as recession or boom, is a domestic factor, where a strong economy may lead to increased interest rates.
• Foreign trade deficits/surpluses are foreign factors.

Financial Instrument (Security)

• A contractual obligation that provides a claim on future cash flow/asset.
• U.S. Treasury bills, commercial paper, and certificates of deposit (CDs) are safe or very safe and are short term (1 year or less).
• Commercial loans from banks, U.S. Treasury notes and bonds (10+ years), mortgages, and bonds (corporate and municipal) are longer term (more than 1 year).
• Common and Preferred stock are also financial instruments
• US t-bills are sold by the government and are 100% safe.
• CDs are sold by banks.
• Commercial paper is sold by commercial companies (e.g., Disney, Apple).

Financial Institutions

• These are intermediaries between providers and users of funds, facilitating transfers of capital.
• These include commercial banks, investment banks, savings & loans, mutual saving banks and credit unions, life insurance companies, mutual funds, exchange traded funds (ETFs), pension funds, and hedge funds.
• Investment banks are used by governments when large sums of money are needed.

Markets

• Locations where securities are bought and sold
• A financial market exchanges one asset (usually cash) for another.
• These can involve physical assets versus financial assets
• Types: spot versus future markets (immediate versus later delivery), money versus capital markets (safe short-term securities versus riskier), and primary versus secondary markets.

Primary vs Secondary Markets

• Primary market example involves the company, Nvidia, getting the money is the seller.
• Secondary market example involves you owning Nvidia stock and selling it to Molly via a broker who gets a cut.

Chapter 2: Income Statement

• Sales less COGS, depreciation expense, and other expenses equals EBIT (earnings before interest and taxes).
• Pretax earnings (ebt) equals EBIT less interest.
• Taxes (25%) of ebt are paid to the IRS.
• Net income is what's left for shareholders.

Balance Sheet

• Assets equal liabilities plus equity.

Assets

• Assets include cash, short-term investments, accounts receivable (A/R), and inventories.
• Total current assets (CA) are liquid assets easily converted to cash.
• Gross fixed assets (FA) less depreciation equals net fixed assets.
• Total assets equal CA + NET FA.

Liabilities and Equity

• Total liabilities equal current liabilities (CL) plus long-term debt (LTD).
• Current liabilities include accounts payable (A/P), notes payable (N/P), and accruals.
• Total current liabilities represent what is owed.
• Total owners' equity includes common stock and retained earnings.
• Net working capital (Net WC) equals CA - CL and should be a positive number.

Statement of Cash Flows

• Tracks operating, investing, and financing activities.

• Financing methods:

  • Method 1: all equity (no borrowing)
  • Method 2: borrow (using equity and debt)

• Operating activities (Net income, adjustments depreciation, CHANGE in A/R, CHANGE in inventory, CHANGE in A/P, CHANGE in accruals) -(cash flow from ops)CFO: Net cash provided/used by operating activities:

• Investing activities (Cash used to acquire fixed assets (gross FA; not net FA), Change in S-T invest) -CFI: Net cash provided/used by investing activities:

• Financing activities (Change in notes payable, Change in long-term debt, Payment of cash dividends) -CFF: Net cash provided (used) by financing activities

• FCF (free cash flow) is the amount of cash available for distribution to investors

5 uses of FCF

• Pay interest on debt
• Pay back principal on debt
• Pay dividends
• Buy back stock (from shareholders)
• Buy non-operating assets