CHAPTER 1.

An Overview of Financial Management Sarbanes-Oxley Act

- Law passed by Congress that requires the CEO
Finance and CFO to certify that their financial
- System that includes the circulation of money, statements are accurate
granting credit, making of investments, and
provision of banking facilities Finance grew out of economics and accounting,
economists developed the notion that an asset’s value
AREAS OF FINANCE is based on the future cash flows the asset will provide,
1. Financial Management and accountants provided information regarding the
- Also called corporate finance likely size of those cash flows.
- Focuses on decisions relating to how much and
what types of assets to acquire, how to raise FORMS OF BUSINESS ORGANIZATION
capital needed to purchase assets, and how to 1. Proprietorship
run the firm so as to maximize its value - Unincorporated business owned by one
individual
2. Capital Markets - Easy and inexpensive to form
- Where interest rates, along with stock and bond - Subject to few governmental regulations
prices, are determined - Subject to lower income taxes unlimited
- Financial institutions that supply capital to personal liability for the business’ debts
businesses - Life of the business is limited to the life of the
individual who created it, to bring in equity,
Federal Reserve System – regulates banks and investors require a change in its structure
controls the supply of money - Difficulty obtaining large sums of capital

Securities and Exchange Commission (SEC) – 2. Partnership

regulates the trading of stocks and bonds in public - Legal arrangement between two or more
markets people who decide to do business together
- Can be established easily and inexpensively
3. Investments - Income is allocated on a pro rata basis to
- Decisions concerning stocks and bonds and partners and taxed on an individual basis
include a number of activities: - Subject to unlimited personal liability

a. Security Analysis – deals with finding the 3. Corporation

proper values of individual securities - Legal entity created by a state
b. Portfolio Theory – deals with the best way to - Separate and distinct from its owners and
structure portfolios, or baskets, of stocks and managers
bonds - Limited liability
c. Market Analysis – deals with the issue of - Subject to double taxation
whether stock and bond markets at any given
time are too high, too low, or about right S Corporations
- Taxed as if they were proprietorships or
Behavioral Finance – where investor psychology is partnerships
examined in an effort to determine whether stock prices - Exempt from corporate income tax
have been bid up to unreasonable heights in a - Have no more than 100 stockholders
speculative bubble or driven down to unreasonable lows
in a fit of irrational pessimism 4. Limited Liability Company and Partnership

• Board of Directors Limited Liability Company (LLC)

- Top governing body - Hybrid between a partnership and a corporation
- Used by other businesses
• Chairperson
- Highest-ranking individual Limited Liability Partnership (LLP)
- Used for professional firms in the fields of
• Chief Executive Officer accounting, law, and architecture
- Provide limited liability but taxed as
• Chief Operating Officer partnerships
- Often designated as a firm’s president - Investors have votes in proportion to their
- Directs firm’s operations (marketing, ownership interest
manufacturing, sales)
• Limited liability reduces the risks borne by
• Chief Financial Officer investors
- Generally senior vice president and the third- • Lower the firm's risk, the higher its value
ranking officer • Firm’s value is dependent on its growth
- In charge of accounting, finance, credit policy, opportunities which are dependent on its ability
decisions regarding asset acquisitions, and to attract capital
investor relations • Value of an asset depends on its liquidity
 • Corporate investment is relatively liquid Compensation Packages
• The main financial goal of firms is to create - Should be sufficient to attract and retain able
value to investors managers but should no go beyond what is
• The larger the expected cash flows and the needed
lower the perceived risk, the higher the stock’s - Needs to be consistent over time
price - Because intrinsic value is not observables,
• True expected cash flows and true risk from compensation must be based on the stock’s
perceived cash flows and perceived risk market price, but the price used should be an
average over time rather than on a specific date
True – cash flows and risk that investors would expect
if they had all of the information that existed about a Rule 14a-11 under the 1934 SEC Act
company - Requires public companies to permit any
shareholder owning at least 3% of a public
Perceived – what investors expect, given the limited company’s voting stock for at least three years
information they have to include director nominations in the
company’s proxy materials

• If a firm’s stock is undervalued, corporate riders

will see it as a bargain and will attempt to
capture the firm in a hostile takeover
• It’s bad for stockholders and managers when
the intrinsic value is high but the actual price is
low
• Managers should try to maximize stock’s
intrinsic value and then communicate
effectively with stockholders. That will cause the
intrinsic value to be high and the actual stock
price to remain close to the intrinsic value over
time

Stockholder-Debtholder Conflicts
Intrinsic Value - Debtholders generally receive fixed payments
- Estimate of the stock’s true value as calculated regardless of how well the company does, while
by a competent analyst who has the best stockholders do better when the company does
available data better
- We can estimate but we can’t be sure that we - The more debt a firm uses to finance a given
are right amount of assets, the riskier the firm becomes
- Managers’ estimates of intrinsic values are
generally better than those of outside investors Covenants
- Intrinsic value rises because the firm retains - Limit firms’ use of additional debt and constrain
and reinvests earnings each year, which tends managers’ actions in other ways
to increase profits
- Long-run concept, management’s goal should Ethics
be to take actions designed to maximize the - Standards of conduct or moral behavior
firm’s intrinsic value, not its current market price
Business Ethics
Market Price - Company’s attitude and conduct towards its
- Actual market price based on perceived but employees, customers, community, and
possibly incorrect information as seen by the stockholders
marginal investor, because not all investors
would agree 1. Sarbanes-Oxley Act of 2002
- To impose sanctions on executives who sign
Equilibrium financial statements later found to be false
- When a stock’s actual market price is equal to
its intrinsic value 2. Dodd-Frank Act
- There is no pressure for a change in the stock’s - Implement an aggressive overhaul of the U.S.
price financial regulatory system aimed at preventing
reckless actions that would cause another
Corporate Governance financial crisis
- Putting in place a set of rules and practices to
ensure that managers act in shareholders’ • Companies benefit from having good
interests while also balancing the needs of reputations and are penalized by having bad
other key constituencies ones
CHAPTER 2. Financial Markets and Institutions 3. Spot Markets
- Assets are bought or sold for on-the-spot
• People and organizations with surplus funds delivery
are saving today in order to accumulate funds
for some future use 4. Futures Markets
• Those with surplus funds expect to earn a - Participants agree today to buy or sell an asset
return on their investments, while those that at some future date
need capital understand that they must pay - Can reduce or hedge the risks faced by parties
interest to those who provide capital involved
• In a well-functioning economy, capital flows
efficiently from those with surplus capital to 5. Money Markets
those who need it - Short-term, highly liquid debt securities

1. Direct Transfers 6. Capital Markets

- Business sells its stocks or bonds directly to - Intermediate or long-term debt and corporate
savers, without going through any type of stocks
financial institution
- Business delivers its securities to savers, who, 7. Primary Markets
in turn, give the firm the money it needs - Where corporations raise new capital
- Used mainly by small firms, and relatively little - Corporation selling the newly created stock,
capital receives the proceeds from the sale

2. Investment Banks 8. Secondary Markets

- Underwrites and facilitates the issuance of - Markets in which existing, already outstanding
securities securities are traded among investors
- Company sells its stocks or bonds to the - Also exist for mortgages, other types of loans,
investment bank, which then sells these same and other financial assets
securities to savers
- Businesses’ securities and the savers’ money 9. Private Markets
merely pass through investment bank - Where transactions are negotiated directly
- But it may not be able to resell the securities to between two or more parties
savers for as much as it paid - Bank loans and private debt placements with
- Primary market transaction insurance companies

3. Financial Intermediary 10. Public Markets

- Obtains funds from savers in exchange for its - Where standardized contracts are traded on
securities organized exchanges
- Uses this money to buy and hold businesses’ - Common stock and corporate bonds
securities, and the savers hold the - Held by a large number of individuals
intermediary’s securities - Have fairly standardized contractual features
- Create new forms of capital because public investors do not generally have
- Greatly increases the efficiency of money and the time and expertise to negotiate unique, non-
capital markets standardized contracts

• Economic development is highly correlated with Financial markets have experienced changes in recent
the level and efficiency of financial markets and years. Technological advances in computers and
institutions. It is difficult for an economy to reach telecommunications, along with the globalization of
its full potential if it doesn’t have access to a banking and commerce, have led to deregulation, which
well-functioning financial system. has increased competition throughout the world.
• People and organizations wanting to borrow
money are brought together with those who Globalization has exposed the need for greater
have surplus funds in the financial markets cooperation among regulators at the international level,
but the task is not easy.
TYPES OF MARKETS
1. Physical Asset Markets Factors that complicate coordination:
- Tangible or real asset markets • Different structures in nations’ banking and
- Wheat, autos, real estate, computers, and securities industries
machinery • Trend toward financial services conglomerates,
which obscures developments in various
2. Financial Asset Markets market segments
- Deal with stocks, bonds, notes, and mortgages • Reluctance of individual countries to give up
- Also deal with derivative securities whose control over their national monetary policies
values are derived from changes in the prices
of other assets Derivative
- Any security whose value is derived from the
price of some other underlying asset
 - Can be used to reduce risks or to speculate • Indexed Funds
- Based on changes in interest rates, foreign - Designed to simply replicate the performance of
exchange rates, or stock prices a specific market index

Credit Default Swaps 8. Exchange Traded Funds (ETFs)

- Are contracts that offer protection against the - Similar to regular mutual funds and are often
default of a particular security operated by mutual fund companies
- Buy a portfolio of stocks of a certain type and
Speculation then sell their own shares to the public
- Done in the hope of high returns, but it raises - Generally traded in the public markets
risk exposure
9. Hedge Funds
FINANCIAL INSTITUTIONS - Also similar to mutual funds because they
1. Investment Banks accept money from savers and use the funds to
- Traditionally help companies raise capital buy various securities
- Help corporations design securities with - Mutual funds and ETFs are registered and
features that are currently attractive to investors regulated by the SEC, hedge funds are largely
- Buy these securities from the corporation unregulated
- Resell them to savers - Typically have large minimum investments and
- Investment bankers are called underwriters are marketed primarily to institutions and
individuals with high net worths
2. Commercial Banks
- Traditional department stores of finance 10. Private Equity Companies
because they serve a variety of savers and - Organizations that operate much like hedge
borrowers funds, but rather than purchasing some of the
stock of a firm, private equity players buy and
3. Financial Services Corporations then manage entire firms
- Large conglomerates that combine many - Most of the money used to buy the target
different financial institutions within a single companies is borrowed
corporation - Not regulated

4. Credit Unions Physical Location Exchanges

- Cooperative associations whose members are - Tangible entities
supposed to have a common bond, such as - Occupies its own building
being employees of the same firm - Allows a limited number of people to trade on
- Members’ savings are loaned only to other its floor
members - Has an elected governing body, board of
- Often the cheapest source of funds available to governors
individual borrowers - Most of the larger investment banks operate
brokerage departments
5. Pension Funds - Security exchanges facilitate communication
- Retirement plans funded by corporations or between buyers and sellers
government agencies for their workers and - Exchange members with sell orders offer the
administered primarily by the trust departments shares for sale and they are bid for by the
of commercial banks or life insurance members with buy orders (auction markets)
companies
- Invest primarily in bonds, stocks, mortgages, Over-the-Counter (OTC) and the NASDAQ Stock
and real estate Markets
- Some brokerage firms maintain an inventory of
6. Life Insurance Companies such stocks and stand prepared to make a
- Take savings in the form of annual premiums market for them
- Invest these funds in stocks, bonds, real estate, - These “dealers” buy when individual investors
and mortgages want to sell, and they sell part of their inventory
- Make payments to the beneficiaries of the when investors want to buy
insured parties
Dealer Markets
7. Mutual Funds - Includes all facilities that are needed to conduct
- Corporations that accept money from savers security transactions, but the transactions are
and then use these funds to buy stocks, leong- not made on the physical location exchanges
term bonds, or short-term debt instruments - Consists of relatively few dealers who hold
issued by businesses or government units inventories of these securities and who are said
- Pool funds and thus reduce risks by to make a market in these securities
diversification - Thousands of brokers who act as agents in
bringing the dealers together with investors
• Actively Managed Funds
- Try to outperform the overall markets
 - The computers, terminals, and electronic - Commonly used benchmark for the U.S. stock
networks that provide a communication link market
between dealers and brokers
- The dealers who make a market in a particular 3. NASDAQ Composite Index
stock quote the price at which they will pay for - Measures performance of all stocks listed on
the stock (bid price) and the price at which they them
will sell the shares (ask price) - Generally regarded as an economic indicator of
- Bid-ask spread, difference between bid and ask the high-tech industry
prices, represents the dealer’s markup or profit
- The dealer’s risk increases when the stock is Market Price
more volatile or when stock trades infrequently - Current price of a stock
- We expect volatile, infrequently traded stocks to
have wider spreads in order to compensate the Intrinsic Value
dealers for assuming the risk of holding them in - Price at which the stock would sell if all
inventory investors had all knowable information about a
stock
Privately Owned or Closely Held Corporations
- Small companies that has common stock that Equilibrium Price
are not actively traded and are owned by - Price that balances buy and sell orders at any
relatively few people, usually companies’ given time
managers - Price remains relatively stable until new
information becomes available and cause the
Publicly Owned Corporations price to change
- Stocks of most large companies are owned by
thousands of investors, most of whom are not Efficient Market
active in management - Market in which prices are close to intrinsic
- Publicly held stock values and stocks seem to be in equilibrium

TYPES OF STOCK MARKET TRANSACTIONS

1. Outstanding shares of established publicly
owned companies that are traded: The
Secondary Market
2. Additional shares sold by established publicly
owned companies: The Primary Market
3. Initial public offerings made by privately held
firms: The IPO Market

Oversubscribed Arbitrage
- Demand for shares at the offering price - In an inefficient market, it might be possible to
exceeds the number of shares issued purchase the company’s stock at a low price
- Investment bankers favor large institutional and then be able to turn around and sell it at a
investors and small investors find it hard to get higher price making a profit
in on the ground floor
Efficient Markets Hypothesis (EMH)
Dutch Auction - Cornerstones of modern finance theory
- Actual transaction price is set at the highest - On average, asset prices are about equal to
price (clearing price) that causes all of the their intrinsic values
offered shares to be sold - If a stock’s price is too low, rational traders will
quickly take advantage of this opportunity and
Stock Market Indexes buy the stock, pushing prices up to the proper
- Designed to show the performance of the stock level
market - If prices are too high, rational traders will sell
- Used as a benchmark for comparing individual the stock, pushing price down to its equilibrium
stocks with the overall market, for measuring level
the trend in stock prices over time, and for - These forces keep prices from being
determining how various economic factors systematically wrong
affect the market
Behavioral Finance Theory
1. Dow Jones Industrial Average - It is often difficult or risky for traders to take
- 1896 by Charles H. Dow advantage of mispriced assets
- Mispricings can occur in the first place
2. S&P 500 Index - Gamblers who are ahead tend to take on more
- 1926 risk, those that are behind then to be more
- Wildly regarded as the standard for measuring conservative
large-cap U.S. stock market performance
- Weighted by each stock’s market value
CHAPTER 3. Financial Statements, Cash Flow, and Depreciation
Taxes - Firms often use accelerated depreciation for tax
purposes but straight-line depreciation for
Annual Report stockholder reporting
- Most important report that corporation’s issue to
stockholders Book Value
- There is a verbal section, often presented as a - Accounting numbers
letter from the chairperson and describes the
firm’s operating results during the past year and Market Values
discusses new developments that will affect - What the assets would sell for if they were
future operations offered for sale
- Provides these four basic financial statements:
2. Income Statement
1. Balance Sheet - Shows the firm’s sales and costs during some
- Shows what assets the company owns and who past period
has claims on those assets as of a given date
- Snapshot of a firm’s position at a specific point Earnings Per Share (EPS)
in time - The bottom line
- Most important to stockholders
• Stockholders’ Equity
- Amount that stockholders paid to the company Operating Income
when they bought shares the company sold to - Derived from the firm’s regular core business
raise capital - Also called EBIT, earnings before interest and
- Can also be thought of as a residual taxes

Stockholders’ Equity Operating Income = Sales Revenues – Operating Costs

= Paid-In Capital + Retained Earnings
= Total Assets – Total Liabilities Depreciation
- Annual charge against income that reflects the
• Retained Earnings estimated dollar cost of the capital equipment
- Cumulative total of all of the earnings the and other tangible assets that were depleted in
company has earned and retained during its life the production process

• Assets are listed by liquidity and liabilities are Amortization

listed in the order in which they must be paid - Represents the decline in value of intangible
assets such as patents, copyrights, trademarks,
Cash vs. Other Assets and goodwill
- Only cash and equivalents represents actual
spendable money EBITDA – earnings before interest, taxes, depreciation,
- A/R are credit sales that have not yet been and amortization
collected
- Noncash assets should generate cash over Retained Earnings for the year = Net Income –
time but they do not represent cash in hand Dividends Paid

Working Capital 3. Statement of Cash Flows

- Current assets because these assets turn over, - Shows how much cash the firm began the year
they are used and then replaced throughout the with, how much cash it ended up with, and what
year it did to increase or decrease its cash

Net Working Capital = Current Assets – Current a. Operating Activities

Liabilities - Items that occur as part of normal ongoing
operations
Net Operating Working Capital (NOWC) = (Current
Assets – Excess Cash) – (Current Liabilities – Notes • Net Income
Payable) - First operating activity and first source of cash
• Depreciation and Amortization
Total Debt = Short-Term Debt + Long-Term Debt • Increase In Inventories
• Increase in Accounts Receivable
Total Liabilities = Total Debt + (Accounts Payable + • Increase in Accounts Payable
Accruals) • Increase in Accrued Wages and Taxes
• Net Cash provided by Operating Activities
Other sources of funds - All previous items are part of normal
• Short-term debt, long-term debt, and common operations and arise as a result of doing
equity business
• Preferred stock, convertible bonds, and long- - When we sum all of it, we obtain the net cash
term leases (hybrid securities) flow from operations
 b. Investing Activities • Changes in interest rates and inflation affect the
- Activities involving long-term assets market value of the company’s assets and
- Purchase and sale of short-term investments, liabilities but often have no effect on the
other than trading securities, and lending and corresponding book values shown in the
collecting on notes receivables financial statements
• Accounting statements do not reflect market
• Additions to PPE values so they are not sufficient for purposes of
- An outflow evaluating managers’ performance
• Net Cash used in Investing Activities
Market Value Added (MVA)
c. Financing Activities - Difference between the market value of a firm’s
- Increase in notes payable, increase in bonds equity and the book value as shown on the
(long-term debt), payment of dividends to balance sheet, with market value found by
stockholders multiplying the stock price by the number of
- Net cash provided by financing activities shares outstanding
- Higher MVA, the better the job management is
Summary doing
- Net decrease in cash and cash and cash - Applies to entire firm
equivalents at the beginning and end of the year
Economic Value Added (EVA)
4. Statement of Stockholders’ Equity - Estimate of a business’ true economic profit for
- Shows the amount of equity the stockholders a given year
had at the start of the year, the items that - Differs from accounting net income
increased or decreased equity, and the equity - Takes into account the total dollar cost of all
at the end of the year capital that includes both the cost of debt and
equity capital
• Financial statements report what has actually - Excess of NOPAT over capital costs
happened while verbal statements attempt to - If EVA is positive, then after-tax operating
explain why things turned out the way they did income exceeds the cost of the capital needed
and what might happen in the future to produce that income, and management’s
• Information in the annual report can be used to actions are adding value for stockholders
help forecast future earnings and dividends - Determined for divisions as well as for the
company as a whole
Retained Earnings
- Represents a claim against assets, not assets EVA = NOPAT – Annual Dollar Cost of Capital
per se = EBIT (1 – T) – (Total Invested Capital x After-Tax
- Do not represent cash and are not available for Percentage of Cost of Capital)
dividends or anything else
• Companies creates value and realize positive
• Even if investors receive accurate accounting EVA if the benefits of their investments exceed
data, it is cash flows, not accounting income, the cost of raising the necessary capital
that matters most • Total invested capital represents the amount of
money that was raised from debt, equity, and
Free Cash Flow any other sources of capital
- Amount of cash that could be withdrawn without
harming a firm’s ability to operate and to Individual Taxes
produce future cash flows - Individuals pay taxes on wages and salaries, on
investment income (dividends, interest, and
FCF = <EBIT (1 – T) + Depreciation and Amortization> profits from the sale of securities), and on the
- <Capital Expenditures + Net Operating Working profits of proprietorships and partnerships
Capital>
Progressive
EBIT (1 – T) = Net Operating Profit After Taxes (NOPAT) - The higher one’s income, the larger the
percentage paid in taxes
• Most rapidly growing companies have negative - Tax system where the tax rate is higher on
FCFs, the fixed assets and working capital higher incomes
needed to support a firm’s rapid growth
generally exceed cash flows form its existing Taxable Income
operations, which is not bad provided a firm’s - Gross income less a set of exemptions and
new investments are eventually profitable and deductions
contribute to its FCF
• Items reported on the financial statements Marginal Tax Rate
reflect historical, in the past, values and not - Tax rate on the last dollar of income
current market values - May exceed 50%
 • When you buy a capital asset and later sell it for • The larger the depreciation, the lower the
more than you paid, you earn a profit (capital taxable income, the lower the tax bill, thus
gain), when you suffer a loss (capital loss) higher operating cash flow
• If you held the asset for a year or less, you have
short-term capital gain or loss, while if you held
it for more than a year, you have long-term
capital gain or loss
• If you sell the stock and there is no gain or loss,
no tax is due

Double Taxation of Corporate Income

- Income is first taxed at the corporate rate, then
what is left is paid out as dividends, and it is
taxed again

• Lower capital gains and dividend tax rates

stimulate capital formation and investment

Types of Individual Retirement Accounts (IRA)

1. Traditional IRAs
- Individual retirement arrangements in which
qualified contributions are tax deductible and
income and capital gains on investments within
the account are not taxed until the money is
withdrawn after age 59 and ½

2. Roth IRAs
- Individual retirement arrangements in which
contributions are not tax deductible but the
future income and capital gains within these
accounts are not taxed if the money is
withdrawn after age 59 and ½

Alternative Minimum Tax (AMT)

- Created by Congress to make it more difficult
for wealthy individuals to avoid paying taxes
through the use of various deductions

After-Tax Income = Pretax Income (1 – T)

Pretax income needed to pay $1 of dividends

= $1/ 1 – Tax Rate

• Corporate tax system favors debt financing

over equity financing

Carryback and Carryforward

- Ordinary corporate operating losses can be
carried backward for 2 years and carried
forward for 20 years to offset taxable income in
a given year

Consolidated Corporate Tax Returns

- If a corporation owns 80% or more of another
corporation’s stock, it can aggregate income
and file one consolidated tax return
- This allows the losses of one company to be
used to offset the profits of another

S Corporation
- A small corporation that, under subchapter S of
the Internal Revenue Code, elected to be taxed
as a proprietorship or a partnership yet retains
limited liability and other benefits of the
corporate form of organization