Key Concepts and Skills • Know the basic types of financial management decisions and the role of the financial manager • Know the financial implications of the different forms of business organization • Know the goal of financial management • Understand the conflicts of interest that can arise between owners and managers • Understand the various types of financial markets and financial institutions • Understand current trends in Canadian financial markets
Chapter Outline • Corporate Finance and the Financial Manager • Forms of Business Organization • The Goal of Financial Management • The Agency Problem and Control of the Corporation • Financial Markets and the Corporation • Financial Institutions • Trends in Financial Markets and Financial Management • Outline of the Text
Corporate Finance 1.1 LO1 • Some important questions that are answered using finance • What long-term investments should the firm take on? • Where will we get the long-term financing to pay for the investment? • How will we manage the everyday financial activities of the firm?
Financial Manager LO1 • Financial managers try to answer some or all of these questions • The top financial manager within a firm is usually the Chief Financial Officer (CFO) • Treasurer – oversees cash management, capital expenditures and financial planning • Controller – oversees taxes, cost accounting, financial accounting and data processing
Financial Management Decisions LO1 • Capital budgeting • What long-term investments or projects should the business take on? • Capital structure • How should we pay for our assets? • Should we use debt or equity? • Working capital management • How do we manage the day-to-day finances of the firm?
Forms of Business Organization 1.2 LO2 • Three major forms in Canada • Sole proprietorship • Partnership • General • Limited • Corporation • In other countries, corporations are also called joint stock companies, public limited companies and limited liability companies
Advantages Easiest to start Least regulated Single owner keeps all the profits Taxed once as personal income Disadvantages Unlimited liability Limited to life of owner Equity capital limited to owner’s personal wealth Difficult to sell ownership interest Sole Proprietorship LO2 A business owned by a single individual.
Advantages Two or more owners More human and financial capital available Relatively easy to start Income taxed once as personal income Disadvantages Unlimited liability General partnership Limited partnership Partnership dissolves when one partner dies or wishes to sell Difficult to transfer ownership Possible disagreements between partners Partnership LO2 A business formed by two or more co-owners.
Advantages Limited liability Unlimited life Separation of ownership and management Transfer of ownership is easy Easier to raise capital Disadvantages Separation of ownership and management Double taxation (income is taxed at the corporate rate and then dividends are taxed at the personal rate) Corporation LO2 A business created as a distinct legal entity owned by one or more individuals or entities.
Income Trust LO2 • Holds the debt and equity of an underlying business. • Distributes the income generated to the unit-holders. Income was not taxed at corporate level. This will change in 2011. • Not a corporation, but unit-holders do have limited liability protection. • Many income trusts are now converting to corporations.
Goal Of Financial Management 1.3 LO3 • What should be the goal of a corporation? • Maximize profit? • Minimize costs? • Maximize market share? • Maximize the current value of the company’s stock? • Does this mean we should do anything and everything to maximize owner wealth?
Primary Goal of Financial Management LO3 • Three equivalent goals of financial management: • Maximize shareholder wealth • Maximize share price • Maximize firm value
The Agency Problem 1.4 LO4 • Agency relationship • Principal hires an agent to represent their interests • Stockholders (principals) hire managers (agents) to run the company • Agency problem • Conflicts of interest can exist between the principal and the agent • Agency costs • Direct agency costs • Indirect agency costs
Managing Managers LO4 • Managerial compensation • Incentives can be used to align management and stockholder interests • The incentives need to be structured carefully to make sure that they achieve their goal • Corporate control • The threat of a takeover may result in better management • Conflicts with other stakeholders
Social Responsibility and Ethical Investing LO5 • Investors are increasingly demanding that corporations behave responsibly • Issues include how a corporation treats the community in which it operates, their customers, corporate governance, their employees, the environment and human rights • Controversial business activities include alcohol, gaming, genetic engineering, nuclear power, pornography, tobacco and weapons
Work the Web Example • The Internet can help investors to research a company’s social responsibility record • One excellent site is www.jantziresearch.com • Click on the web surfer to go to the site, choose a company and see what information you can find!
Work the Web Example • The Internet provides a wealth of information about individual companies • One excellent site is finance.yahoo.com • Click on the web surfer to go to the site, choose a company and see what information you can find!
What is the role of financial markets in corporate finance? 1.5 LO5 • Cash flows to and from the firm • Money vs. capital markets • Primary vs. secondary markets • One excellent site for information on Canadian companies that trade in secondary markets is www.tmx.com • Click on the web surfer to go to the site, choose a company and see what information you can find!
Financial Institutions 1.6 LO5 • Financial institutions act as intermediaries between suppliers and users of funds • Institutions earn income on services provided: • Indirect finance – Earn interest on the spread between loans and deposits • Direct finance – Service fees (i.e. bankers acceptance and stamping fees)
Trends in Financial Markets and Management 1.7 LO5 • Financial Engineering • Derivative Securities • Advances in Technology – i.e. E-business • Deregulation • Corporate Governance Reform • Hedge Funds • Sub-prime Market
Outline of Text 1.8 Part 1: Overview of Corporate Finance Part 2: Financial Statements and Long-Term Financial Planning Part 3: Valuation of Future Cash Flows Part 4: Capital Budgeting Part 5: Risk and Return Part 6: Cost of Capital and Long-Term Financial Policy Part 7: Short-Term Financial Planning and Management Part 8: Topics in Corporate Finance Part 9: Derivative Securities and Corporate Finance
Quick Quiz • What are the three types of financial management decisions and what questions are they designed to answer? • What are the three major forms of business organization? • What is the goal of financial management? • What are agency problems and why do they exist within a corporation? • What is the difference between a primary market and a secondary market?
Summary 1.9 • You should know: • The advantages and disadvantages between a sole proprietorship, partnership and corporation • The primary goal of the firm • What an agency relationship and agency cost are • What ethical investing is • The role of financial markets
Chapter Outline • The Balance Sheet • The Income Statement • Cash Flow • Taxes • Capital Cost Allowance • Summary and Conclusions
Balance Sheet - 2.1 LO1 • The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time • Assets are listed in order of liquidity • Ease of conversion to cash • Without significant loss of value • Balance Sheet Identity • Assets = Liabilities + Stockholders’ Equity
Net Working Capital and Liquidity LO1 • Net Working Capital • Current Assets – Current Liabilities • Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out • Usually positive in a healthy firm • Liquidity • Ability to convert to cash quickly without a significant loss in value • Liquid firms are less likely to experience financial distress • However, liquid assets earn a lower return • Tradeoff between liquid and illiquid assets
Market Vs. Book Value LO1 • The balance sheet provides the book value of the assets, liabilities and equity. • Market value is the price at which the assets, liabilities or equity can actually be bought or sold. • Market value and book value are often very different. Why? • Which is more important to the decision-making process?
Income Statement - 2.2 LO1 • The income statement is more like a video of the firm’s operations for a specified period of time. • You generally report revenues first and then deduct any expenses for the period • Matching principle – GAAP say to show revenue when it accrues and match the expenses required to generate the revenue
The Concept of Cash Flow - 2.3 LO2 • Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements • We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets
Cash Flow From Assets LO3 • Cash Flow From Assets (CFFA) = Cash Flow to Bondholders + Cash Flow to Shareholders • Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC
Example: Canadian Enterprises LO3 • OCF (I/S) = EBIT + depreciation – taxes = $509 • NCS (B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation = $130 • Changes in NWC (B/S) = ending NWC – beginning NWC = $330 • CFFA = 509 – 130 – 330 = $49 • CF to Creditors (B/S and I/S) = interest paid – net new borrowing = $24 • CF to Stockholders (B/S and I/S) = dividends paid – net new equity raised = $25 • CFFA = 24 + 25 = $49
Example: Balance Sheet and IncomeStatement Information LO3 • Current Accounts • 2008: CA = 1500; CL = 1300 • 2009: CA = 2000; CL = 1700 • Fixed Assets and Depreciation • 2008: NFA = 3000; 2009: NFA = 4000 • Depreciation expense = 300 • LT Liabilities and Equity • 2008: LTD = 2200; Common Equity = 500; RE = 500 • 2009: LTD = 2800; Common Equity = 750; RE = 750 • Income Statement Information • EBIT = 2700; Interest Expense = 200; Taxes = 1000; Dividends = 1250
Example: Cash Flows LO3 • OCF = 2700 + 300 – 1000 = 2000 • NCS = 4000 – 3000 + 300 = 1300 • Changes in NWC = (2000 – 1700) – (1500 – 1300) = 100 • CF From Assets = 2000 – 1300 – 100 = 600 • CF to Bondholders = 200 – (2800 – 2200) = -400 • CF to Shareholders = 1250 – (750 – 500) = 1000 • CF From Assets = -400 + 1000 = 600 • The CF identity holds.
Taxes - 2.4 LO4 • Individual vs. corporate taxes • Marginal vs. average tax rates • Marginal – the percentage paid on the next dollar earned • Average – the percentage of your income that goes to pay taxes (tax bill / taxable income)
Taxes on Investments LO4 • When an investor holds stocks, they are subject to two types of taxes: • Dividend tax credit – A tax formula that reduces the effective tax rate on dividends • Capital gains tax – Tax is paid on the investment’s increase in value over its purchase price
Capital Cost Allowance (CCA) - 2.5 LO5 • CCA is depreciation for tax purposes • CCA is deducted before taxes and acts as a tax shield • Every capital asset is assigned to a specific asset class by the government • Every asset class is given a depreciation method and rate • Half-year Rule – In the first year, only half of the asset’s cost can be used for CCA purposes
Example: CCA Calculation LO5 • ABC Corporation purchased $100,000 worth of photocopiers in 2004. Photocopiers fall under asset class 8 with a CCA rate of 20%. How much CCA will be claimed in 2004 and 2005?
CCA – Additional Concepts LO5 • Usually firms have multiple machines (i.e. more than one photocopier) in an asset class. • When an asset is sold, the asset class is reduced by the realized value of the asset, or by its original cost, whichever is less.
Closing an Asset Class LO5 • When the last asset in an asset class is sold, the asset class is terminated. This can result in a terminal loss or recaptured CCA. • Terminal Loss – The difference between the UCC and the adjusted cost when the UCC is greater. • Recaptured CCA – The taxable difference between the adjusted cost and the UCC when the UCC is smaller.
Another CCA Example LO5 • Kool Drinks Corporation purchased $300,000 worth of bottling machinery in 2007. Machinery falls under asset class 43 with a CCA rate of 30%. In 2009, Kool Drinks sold their machinery for $150,000 and moved their production to Mexico. Was there a capital gain, a CCA recapture or a terminal loss? What if the machinery was sold for $120,000?