Practical financial managment 7e LASHER chapter 1

An Overview of Finance

Areas within Finance
Investments and financial markets
Financial management of corporations
Fields are separate but related

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Financial Assets
Real asset—Objects that provide services: houses, cars, food, etc.

Financial asset—a document representing a claim to future income

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Stock represents ownership interest
Bond represents a debt relationship

Investing involves buying financial assets in the hope of earning more money (a return)

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Investments can be made directly or indirectly through a mutual fund

A Security is a financial asset that can be traded among investors

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Financial Markets

Securities are issued by corporations to raise money, and purchased
by investors in financial markets

– A framework or organization in which people can buy/sell securities
Stock market
Stockbroker is licensed to trade

securities

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Simplified Financial System

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Raising Money

The most common use of the word finance involves raising money
to acquire assets
Forms of Financing

– Issuing stock - equity financing
– Borrowing money - debt financing
– Internal financing - retaining earnings

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Raising Money

The field of finance deals with both raising and investing money,
but:
Changing Focus of Finance

– Past - finance was limited to financial market activity
– Now – Corporate finance includes the financial management of
organizations

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Financial Management

The management and control of money and money-related operations
within a business

CFO – chief financial officer (VP of finance)

– Executive in charge of finance

department

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Financial Management

Functions of the finance department:

– Keeping records
– Receiving payments from customers
– Making payments to suppliers
– Borrowing money
– Purchasing assets
– Selling stock
– Paying dividends

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Business Decisions

Finance department provides:

– Analyses to determine which assets are purchased and how they are
financed

– Oversight of how other departments spend money

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The Price of Securities—A Link Between the Firm and the
Market

Two sides of finance – investments and financial management
Investors buy securities for the cash income expected in the future
Link between company management and investors comes from this
relationship between price and expected financial results

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Accounting and Finance
Broad Portrayal vs. Cash Flow

Accounting statements portray physical activity

The focus in Finance is on future cash

in numbers

flow

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Descriptive

In finance:

Cash is King

Historical

E.g. Depreciation

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Finance and Accounting

Finance department generally consists of both the accounting and
treasury departments

– Controller is in charge of the
– Treasury department deals with

accounting department
other other financial activities

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Figure 1-2 Finance Department Organization

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Concept Connection Example 1-1
Accounting Records and Cash Flow
A $1,000 asset depreciated straight-line over five years:
Accounting perspective – Portrait Over Time
Initial $1,000 cost becomes an asset on books
$200 per year depreciation reduces profit

Book value shrinks as depreciation accumulates
Finance perspective – Focus On Cash Flow
Depreciation deduction saves cash by reducing tax
It took a $1,000 cash outflow to acquire the asset
Where did the money come from
Finance had to raise that money

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The Language of Finance

Accounting is the language of finance

– All finance professionals need some knowledge of accounting
Level depends on job

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Financial analyst needs to know LOTS of accounting
Stockbrokers not as much

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Financial Theory—The Relationship with Economics

Modern financial theory began as a branch of economics in the
1950s

– Originally called “financial economics”
– Theoretical tools are very similar
Finance is a separate but still related field

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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

A businesses can be legally organized as a

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sole proprietorship
partnership
corporation

Legal organization has an impact on

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Raising money
Taxation
Financial liability

For our purposes we’ll combine partner/proprietor

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The Proprietorship Form

Easy to start
Taxes

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Profit is taxed as personal income
Taxed only once

Raising money – Investor’s perspective

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A proprietorship can only borrow (no stock to sell)
But lending money to a new business is risky

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Best outcome: repayment of principal and interest
Worst outcome: lose everything
Most new businesses fail

Result: Collateral required

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The Corporate Form

Getting started

– Requires a legal incorporation process
Takes a little time, work and money

Taxes

– Double taxation
Corporation pays corporate taxes on income
Dividends paid to owners are taxed as personal income

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Concept Connection Example 1-2 Tax Consequences of Business
Form
A business earns $100,000 before taxes.

Owner wants to take the earnings home.
Tax rates: Corporate - 34%
Personal - 30%
Compare total tax bills under corporate and proprietorship forms of organization

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The Corporate Form

Raising Money

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Borrowing

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BUT owner can now offer stock (equity) to investors

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Same issues faced by sole proprietorship

If sell less than 50% can maintain control

From the investor’s perspective

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Stock is a risky investment but the reward may be worth it

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Worst possible outcome: lose entire investment
Best possible outcome: get rich

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The Truth About Limited Liability
Limited liability: stockholder not liable for a corporation’s debts

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Implies that the most a stockholder can lose is 100% of his investment in the stock
True for owners not involved in the business

However, for owner operated small businesses

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Personal guarantees make entrepreneurs liable for loans to their businesses
Legal system holds individuals liable for negligence
These destroy the value of limited liability

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S-Type Corporations and LLCs

Major advantage: Treated as a partnership with respect to federal income taxes

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LLC is replacing S-type

Government encourages small businesses because they create jobs

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S-type corporations and LLCs
Avoid double taxation: profits “pass through” to owners as personal income
Offer limited liability
Offer the ability to sell stock to raise money

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