Laying a Foundation FIN 461: Financial Cases & Modeling

1. Laying a FoundationFIN 461: Financial Cases & Modeling George W. Gallinger Associate Professor of Finance W. P. Carey School of Business Arizona State University

2. Let’s Get Started on Materials • Partially covered in your FIN 361 textbook • Chapters 1, 29 & 14. W. P. Carey School of Business

3. What is Finance? • Finance is derived from the Latin word finis • During Roman times, finis meant the completion of a contract between parties with either a transfer of money or barter (exchange) or a credit agreement • Much the same meaning today • Finance encompasses the analysis of, the issuance of, the distribution of, and the purchase of financial contracts written against real assets (e.g., land, buildings, equipment, and inventories) • Implicit in these activities is the determination of value; deciding what something is worth. W. P. Carey School of Business

4. Areas of Finance • Finance is a multifaceted discipline, international in scope, and bound together by contracts • It includes the areas of: • Managerial finance • Investments • Financial markets. W. P. Carey School of Business

5. Managerial Finance W. P. Carey School of Business

6. Investments • Closest many people get to finance • Personal portfolios • Try to “beat the market” • So much news about investments • Markets open 24 hours per day. W. P. Carey School of Business

7. Financial Markets • A brief discussion later • Key to value creation. W. P. Carey School of Business

8. Relationships • Financial management, investments, and financial markets are closely related: • Accepted financial objective of a company: Maximization of its market value  maximization of shareholder value • Management's actions influence the firm’s market value • Simultaneous interplay of supply and demand for financial securities in financial markets determines market value • Through the mechanism of these financial markets, companies participate as suppliers of securities and investors participate as demanders for securities • Interactions of the demands of all investors determine market values. W. P. Carey School of Business

9. Finance Principles • Finance is an integrated body of knowledge • Built around guiding principles: wealth maximization, time value of money, expected return versus risk, leverage, & diversification • Principles provide the foundation for integrating the areas of finance and provide guidance for the issues. W. P. Carey School of Business

10. Maximization of Wealth • Pursue value-adding activities • Conduct business in an ethical manner. W. P. Carey School of Business

11. Time Value of Money W. P. Carey School of Business

12. Expected Return vs. Risk W. P. Carey School of Business

13. Operating Leverage W. P. Carey School of Business

14. Financial Leverage W. P. Carey School of Business

15. Diversification W. P. Carey School of Business

16. Common Elements Usedin Finance See next slide W. P. Carey School of Business

17. Organizational Form W. P. Carey School of Business

18. Finance & Other Disciplines • As you prepare to study finance, and managerial finance in particular, keep the following perspective in mind • Finance relies on: • Economics • Accounting • Quantitative methods • Management. W. P. Carey School of Business

19. How Ethics & Finance Relate W. P. Carey School of Business

20. Transition to an Accounting Review • Finance is not accounting! • Many firms call the accounting function the finance department • Focus different in finance. W. P. Carey School of Business

21. Accounting Information • Every company has a history—good, bad, or neutral—that is important to managers and potential investors, bankers, or creditors • Firm's history  track record of accomplishments • From a financial perspective, you measure a firm's history by the company's principal financial statements • Balance sheet, income statement, and statement of cash flows • These statements evolve from the accrual accounting process, following accepted principles, procedures, and standards of the accounting profession. W. P. Carey School of Business

22. Manipulation of Earnings Survey W. P. Carey School of Business

23. Funds vs. Profits • Finance is more concerned about funds than about income, or profit • Funds represent financial resources the firm uses to buy inputs (such as material, labor, and assets) and pay investors • Funds come from many sources • Revenue from operations, monies received from lenders, new investments by shareholders, or from the sale of assets • Money represents funds, but so does buying on credit • Profit is the return on investment • The amount received, or benefit gained, by making the investment • Return of investment  recapture of the initial investment as a result of generating cash flows to repay the initial cost. W. P. Carey School of Business

24. EBITDA • Many people define cash flow as EBITDA • What is its relevance? • What is it missing? • Does it do a reasonably good job? • Why not use the statement of cash flows? W. P. Carey School of Business

25. W. T. Grant • Accounting profits versus cash operating profits • Cash flow frequently defined as: Net income + depreciation • Poor definition. • Look at W. T. Grant’s trend... • And then at Salton… W. P. Carey School of Business

26. What Happened to W. T. Grant? W. P. Carey School of Business

27. What Happened to Salton? W. P. Carey School of Business

28. Rules for Identifying Cash Flows Balance Sheet Assets increase Use Financing increases Source Assets decrease Source Financing decreases Use Revenues = Source Expenses = Use W. P. Carey School of Business

29. W. P. Carey School of Business

30. Sustainable Growth • What differentiates firms that create value from those that destroy value? • Ability to manage growth! W. P. Carey School of Business

31. What Does Value Mean? • A central theme of this course is that management’s decisions are directed toward increasing the value of the firm • Necessary to carefully define what value means • The logic of accounting is different from the logic of finance • Accounting often refers to book value of assets • Has little meaning in finance • Finance uses economic value and market value. W. P. Carey School of Business

32. Transition to Economic Foundations • Economics provide theoretical underpinnings. W. P. Carey School of Business

33. Operate in an Economic System • Each financial player or participant purses its goals within the economic system • Economic system allows for the exchange of goods or services and money • Consists of business, government, and household sectors of the economy, all of which interact with each other • While all societies or countries have such sectors, they relate in very different ways in different countries • Government sector is much more predominant in determining outcomes of the economic system in China or Cuba than it is in the United States. W. P. Carey School of Business

34. Fiscal & Monetary Policies • Implementation of fiscal policy and monetary policy are means the government sector uses to alter economic activity of households and businesses • Fiscal policy refers to policies or laws that affect the government budget • Monetary policy involves changes in the economy’s money supply • Responsibility of the nation’s central bank. W. P. Carey School of Business

35. Importance of Finance • A simple model economy to clarify the forces that shape finance • Economy initially has just one person, you, who lives on a deserted island • Your wealth consists of 100 pounds of seed corn • Must meet your needs both now and in the near future • No opportunity exists to produce or increase your initial wealth position, nor can you exchange goods or services with anyone else • Decision: • You must decide how to allocate your wealth between consumption of corn this period and next period • You cannot save corn past the next period. W. P. Carey School of Business

36. Neither Production NorMarkets Exist • You must make a decision: • Consumption this period vs. next period? W. P. Carey School of Business

37. Neither Production NorMarkets Exist W. P. Carey School of Business

38. Introduce Production • Assume 1 lb. of planted seed corn reaps 1.25 lbs. of corn next period: • 55 x 1.25 = 68.75 • Availability increases 13.75 pounds, or 25%, over the earlier situation of no production opportunities W. P. Carey School of Business

39. Introduce ExchangeBetween Participants • With the growth in the number of people, the single-sector economy divides into two sectors • Business sector and household sector • Business sector produces goods and services • Household sector purchases goods and services from the business sector and provides inputs to the business sector so that it can produce the goods and services • To facilitate exchanges of goods and services between sectors, all participants in the economy agree on a form of money. W. P. Carey School of Business

40. Introduce a Financial System • Function of the financial system • Accept excess money of savers and lend it to deficit units in need of funds • This function is made more important by the fact that methods of production often require a volume of money greater than can be generated by the producing firm itself in its early stages of production • E.g.: a firm needs to construct buildings and equipment to manufacture a product • How does the financial system meet the needs of firms by locating, securing, and channeling the money to them? W. P. Carey School of Business

41. Financial Markets & Interest Rates • Interest rate  a reflection of the time value of money • Many factors, including inflation and the risk of default by the borrower, influence the time value of money • Central to this discussion  supply of money and its effect on interest rates • There are in fact several different interest rates: money rates, consumer savings rates, government treasury rates, government agency rates, and corporate rate, among others • Generally, interest rates move in the same direction in response to economic activity • Necessary to distinguish between nominal interest rates and real interest rates. W. P. Carey School of Business

42. Interest Rates Play Key Role W. P. Carey School of Business

43. Example of Resource Allocations W. P. Carey School of Business

44. Example Continued… and DeGrazia W. P. Carey School of Business

45. Types of Financial Markets • Money markets: Short-term maturities of less than one year Capital markets: Long-term maturities exceeding one year Primary market: Initial issuance of newly created securities Secondary market: Transactions subsequent to inital issuance of securities W. P. Carey School of Business

46. Primary Market • Initial sale of securities • Investment bankers major players • Functions: • Investigative • Risk bearing • Selling. W. P. Carey School of Business

47. 2003 Investment Banking Rankings W. P. Carey School of Business

48. Investigative Function • Researches the firm wanting to issue new securities • Is link between the capital markets, the firm issuing the securities, and other investment bankers (i.e., the syndicate) • Draws the covenants and ensures compliance with the laws • Establishes the securities' issuing price. W. P. Carey School of Business

49. Risk-Bearing Function • Basically two extremes: "Take it or leave it“ • Taking it - the investment banker assumes the risk and underwrites the security issue (called a firm-commitment offer) • Leaving it - risk is left with the issuer (called a best-efforts offer) • Investment banker compensated by the spread • Market price minus price to company. W. P. Carey School of Business

50. Selling Function • Securities sold through selling divisions of the underwriters and invited brokerage houses • Formal announcement by: • Red Herring - preliminary and unofficial • Prospectus - official SEC document • Tombstone - an after-the-fact advertisement. W. P. Carey School of Business