Introduction to Financial Management PDF

CHAPTER 1: INTRODUCTION TO FINANCIAL MANAGEMENT The field of finance has numerous careers in a variety of industries. The purpose of this text is to introduce you to the financial management of a corporation. While we can't show you how to perform a specific job, the goal of this text is to give you...

CHAPTER 1: INTRODUCTION TO FINANCIAL MANAGEMENT The field of finance has numerous careers in a variety of industries. The purpose of this text is to introduce you to the financial management of a corporation. While we can't show you how to perform a specific job, the goal of this text is to give you a framework to make financial decisions that add value to your business or organization. Whether a finance major or not, we believe that finance will impact you throughout your career. If you are a human resources officer, you may use finance tools to determine the value of a benefits package. If you are an Information Technology director, you may use finance to value an opportunity to increase server capacity. If you are a brand manager for a corporation, you may value the opportunity to extend your product line. Of course, if you are a Chief Financial Officer for a firm, you may use finance to value a potential firm to acquire. The point here is that many decisions in a variety of areas have a finance component. Our goal here is to make you comfortable when these occasions arise. AREAS OF FINANCE We start by trying to briefly describe three areas of finance and some related finance careers. This is not exhaustive but it at least tries to describe some career opportunities. The first area is Money and Banking. The goal of a bank is to bring borrowers and lenders together. In other words, the bank is a financial intermediary (i.e. middle man) that facilitates transactions between two parties. In a local economy, the bank is then an economic engine for growth as loans to small businesses create jobs and cash flows to the local economy. Finance careers with local banks can deal with mortgages or commercial lending. On the national level, money and banking is found within the Federal Reserve System. The goal of the Federal Reserve is to adjust the money supply to adjust interest rates. The money supply is adjusted to achieve a policy goal. In recent years, the Federal Reserve is trying to keep interest rates low to avoid another recession. They would like to see more job growth before allowing rates to increase. A second area of finance is investments. Here, we use a very general term for the idea of valuing and managing assets. On the local level, investments could take the form of advisory services where finance professionals advise consumers on how to invest and manage their money. There is a full range of advisory services depending on the level of assistance the client requires. On a larger scale, investments could be a portfolio or fund manager, which isA second area of finance is investments. Here, we use a very general term for the idea of valuing and managing assets. On the local level, investments could take the form of advisory services where finance professionals advise consumers on how to invest and manage their money. There is a full range of advisory services depending on the level of assistance the client requires. On a larger scale, investments could be a portfolio or fund manager, which is a finance professional who selects a set of stocks for investors. Finally, an additional career is in the field of investment banking. This career is popular with many finance majors because it is lucrative and challenging. Investment blnks try to create opportunities for firms as they constantly pitch ideas that will create value for firms. For example, an investment bank might pitch Coca-Cola on an opportunity to purchase a beverage company in France. If Coca-Cola pursues the idea, the investment bank will make money in helping Coca-Cola create the transaction by issuing the debt and generating a fee. Investment banking can provide lucrative income as a career, but keep in mind that the typical associate works 100 hours per week or more! A third area of finance is financial management. Financial management is basically the finance component of a firm. There are numerous careers in corporate finance ranging from an entry-level analyst all the way to the Chief Financial Officer (CFO). In general, the goal of the firm is to find projects that will add value to its owners. Further, financial managers will try to finance these projects in the most cost effective way possible. The final role for the financial manager is to manage the daily activities of the firm. This includes inventory management, pricino and hiring The goal of the financial manager is to maximize the wealth of the owners, the stockholders. The stockholders have taken the risk to invest in the business, so the financial manager has the duty to make decisions that have shareholder interest in mind. The value of the shareholder's stakes depends on the success of projects and decisions made by the financial manager. Now that we have three main areas of finance, we will discuss guiding principles of finance that will appear throughout the course. GUIDING PRINCIPALS OF FINANCE For this course, there are several core principles that we will focus on throughout the text. The core principles are as follows: Maximization of wealth Time Value of Money Risk versus Return Leverage Diversification We will assume that firms maximize wealth throughout this text. Of course, in the real world, that is not always the case. For instance, non-profits do not maximize wealth, but rather they maximize a social goal. For instance, Habitat for Humanity wants to maximize the number of houses built for deserving families each year. Further, for-profit firms have social goals as well that may reduce overall wealth. For example, CVS decided to quit selling cigarettes in their stores in the past year. This will likely reduce their overall sales revenue, and as a result, it may reduce the company's stock value and wealth of their investors. For our purposes, we will assume that firms maximize wealth from the resources they are given. Our second principle is time value of money. This concept is our approach to valuing future cash flows in today's dollars. We will use this principle to value decisions that involve investor capital. When investors give us capital, they want to be compensated for their opportunity cost. Typically, investors want to be compensated for time and risk. Time is simply the reward an investor wants for delaying consumption until later, while risk is the reward for uncertainty in the project's cash flows. Time value of money will be our most important concept in this text. Our third concept is risk versus return. The idea is that investors will require a greater return for taking on greater risk. By definition, risk is the chance that an outcome differs from expected. Riskier investments have a wider range of possible outcomes than safer investments. In general, we can say that investors are risk-averse, so they expect extra compensation for purchasing investments with greater volatilitv or uncertainty. For instance, let's look Notice that average return increases as the risk level increases. When we factor in volatility, we see a larger range of possible values as we move down the table. The wider range of outcomes investors ask for a larger return. Leverage, our fourth concept, refers to the percentage of debt that a firm uses in its capital structure. If the firm increases it debt proportion, we say that it has added leverage. The impact of leverage adds both extra risk and expected return to the shareholder. The risk added is due to additional debt creating a larger required interest payment. The increased fixed payment means that the firm will have greater volatility in earnings. Why? If sales are higher than normal, the interest on debt is still the same, so income is higher. If sales are lower than normal, the interest on debt is still the same, which leads to lower income. For the return, with increase proportion of debt, the firm will have less shareholder capital, so profits are divided among fewer stakeholders. This translates to a higher expected average return. The final guiding principal is diversification. You probably have had a family member or friend use the expression, "Don't put all your eggs in one basket." This quote expresses the idea of diversification. Investors should invest in multiple assets, so that the performance of one asset does not determine the overall success of the investor. When you are diversified, you have many other assets to offset losses from one particular investment. For instance, you may have applied to multiple schools for college to avoid putting all your hopes on one application. In recent times, Enron Corporation is a good example of a lack of diversification. Enron was a high performing energy company. However, it was revealed that their accounting numbers had been fabricated and that the company was in dire financial condition. Investors sold off all Enron holdings and the company eventually went bankrupt. The tragedy with Enron was that many of their employees had their retirement holdings concentrated in Enron company stock. When the company failed, the value of their retirement holdings was lost as well. If the employees had held a balanced portfolio, the impact of Enron's collapse would have been lessened. The lesson here is that we diversify to avoid one bad event from impacting our future. We will return to these principles throughout the semester. Our next topic is to look at different business types TYPES OF BUSINESS ORGANIZATIONS In general, there are three basic types of businesses. While there are hybrid forms of business forms, our three general types are sole proprietorship, partnerships, and corporations. In our economy, most businesses are sole proprietorships (around 80%), but most of the sales revenue comes from corporations (around 90%). In fact, most of you reading this book will also likely work for a corporation during your career. As a result, our focus in this text will be oh corporations. However, we want to discuss the pros and cons of each type. SLE 44°F Sunny SOLE PROPRIETORSHIP A sole proprietorship is a business owned by a single individual. There are no other parties that own or control the business. The upside of a sole proprietorship is that you can be your own boss and control the future of the business by your skill and work ethic. Another advantage is single taxation. Sole owners are only taxed on income. A final advantage is that sole proprietorships are relatively easy to form. The largest disadvantage to a sole proprietorship is that the owner has unlimited personal liability. Most sole proprietorships obtain a large portion of their financing through bank loans. To obtain a bank loan, the owner must offer collateral from his own personal assets. If the business fails. the bank then has the right to claim personal assets to satisfy the principal owed on the loan. With the high failure rate for small businesses, this is the largest disadvantage for this business form. A second disadvantage for a sole proprietorship is that the owner may have difficulty raising capital to finance the business. Banks and other creditors will not want to make bad loans, so small businesses with little track record of success can have trouble obtaining capital for growth. The type of business can influence this as well. In the first wave of technology firms, Apple and Hewlett Packard were started out of garages. With little track record, both had issues dealing with banks and other lenders who did not : understand the technology and potential of the start-ups. A third disadvantage is the life of the business. Unless provisions are made, the life of a sole proprietorship ends with the life of the owner. Of course, firms are sold or passed down to heirs, but selling a small business can be a challenge. PARTNERSHIP The partnership form of business is where two or more people join together to operate a business. The advantages of partnerships are really the same as a sole proprietorship. Instead of one person, now a group can make their own decisions, and starting a partnership is relatively inexpensive. Again, the taxes facing a partnership are single taxation. The disadvantages of a partnership are similar to a sole proprietorship as well. Again, partnerships can potentially face unlimited liability. However, partners in a business can either be general or limited. A general partner faces unlimited liability, but also shares in all the profit of the business. A limited partner has limited liability and can only lose his or her initial investment. However, a limited partner has no management authority and cannot be legally involved in managerial decision making for the business. Partnerships also have difficulty raising capital without a proven track record of success. Like a sole proprietorship, partnerships have issues when one of the partner wants to leave the business or retires. The firm agreement must allow for the loss of a partner or the company will dissolve when a partner leaves. A final issue unique to partnerships is disagreements between the owners or partners in the firm. Partnerships are like marriages to an extent as the ability for partners to get along is critical to the success of the business. Keep in mind that there are other options to be a small business owner when it comes to the structure of the business. Many small business owners opt instead to form an LLC or Limited Liability Company. An LLC creates limited liability for the owner as long as the owner keeps the transactions of the business separate from personal transactions. The difference between a limited partnership and an LLC is that a member in an LLC can make managerial decisions. An LLC is one of the preferred approaches for entrepreneurs. A corporation is considered by the law to be a living entity and is separate from its owners. As seen in recent case law, a corporation has many of the legal rights that individuals have. A corporation can enter into contracts and buy plant, property, and equipment. The corporation also has legal protection, but it is also solely responsible for its obligations. Corporations must be legally formed and registered or incorporated by permission of a state government. The corporation must then set up a charter that has firm bylaws and initial rules to operating the business. (annual meetings, shareholders, etc.) There is no limit to the number of owners that a corporation may have. Investors purchase shares of ownership or stock in the corporation in exchange for a financial consideration. The shares, called stock, represent equity in the organization. The number of shares owned determine the investor's stake in the corporation. In a corporation, the owners of the firm elect the board of directors who oversee the operations and financial decisions of the firm. The corporate form has some definite advantages over other types of business forms. The main advantage of a corporation is that investors have limited liability. The investor can only lose up to their initial investment. This is a great advantage for the corporations as we generally think of investors as risk averse. A second advantage of the corporate form is that corporations have easier access to capital. Corporations often have a stronger reputation with lenders, and equity investors face less limited liability. Larger corporations have direct banking relationships so raising capital is much easier than other business forms. The third advantage is transfer of ownershin With other forms of husinesses. sellino the husiness or the life of the husiness can be a difficulty With corporations, this is easily accomplished with an online trading account. The main disadvantage of a corporate form is double taxation. Net income is taxed in a corporation as well as any dividends that the corporation pays out to its shareholders. A second minor disadvantage is that corporations tend to be more regulated. Of course, firms can incorporate in different states as regulations do vary around the country. WHY IS THE CORPORATE FORM BEST FOR A FIRM? I To grow a business, firms need money to grow. To gain money or capital, the firm needs investors willing to participate. With the corporate form, there is easier access to capital as investors face limited liability. Despite double taxation, the benefits of less risk to investors and ease of capital makes the corporate form of business more appealing. Next, we look at an overview of where we are going in this course. OVERVIEW OF WHERE WE ARE GOING In an introductory class, our focus is on financial management and creating value for the firm. We will focus on the area of project finance throughout this course as it touches a variety of careers and majors. Project finance is the process of finding opportunities that create value for the firm. There are a few steps in project finance that we will discuss now. Generate Ideas and Proposals: Our first step is to generate ideas and proposals for the firm to consider. For a restaurant owner, this might be expanding his building space or adding a franchise. For a firm like Google, it might be considering the acquisition of another firm. For a local farmer, it might be replacing a key piece of machinery. In other words, projects come in all shapes and sizes. Estimate Cash Flows for the Project: The second step is to estimate incremental cash flows created by the project. This represents the cash flow that we are generating for our investors in our business if we accept the project. We will develop equations in the text to estimate cash flows, but for now, you can think of cash flows as similar to earnings. Estimate the Return Investors Require To Invest: We next evaluate the uncertainty of the incremental cash flows. The degree of uncertainty represents the potential volatility in the cash flows of a project. Investors will need compensation or a return for taking on the volatility in an investment. We will use the required return for our investors to evaluate the proposal. Evaluate the Proposal: Our next step is to estimate the value of the proposal. We determine the return our investors want to fund the proiect. Bv return. we refer to the percentage gain our investors want for the use of their capital. We then determine if the cash flows created by the project can pay our investors the return they want. ★ Investment Decision: The next step is to decide whether to invest in the project or not. We will invest if we believe the project will add value to the business. Evaluate the Results: If we accept and implement the project, we should always review and audit the results. Our goal is to make improvements in how well we forecast cash flows going forward. I Firms run through these general steps continuously as proposals and ideas are always being generated. Our goal then during this text is to introduce the tools needed to evaluate a project finance proposal. To reach our goal, we must learn some basic finance tools first. ★= The finance field is far-reaching and equally varied. There are numerous career paths that a finance degree holder can pursue. In this course, we focus on the area of financial management as it has greatest application to the general business student. Our goal in this text is to introduce a framework for making value-creating decisions that add to shareholder wealth. We start with a review of financial statements.