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Chapter 1: The Corporation and the Financial Manager

Corporate Finance is a segment of finance which deals with the decisions taken by the different corporations. Corporate finance studies and analyses the tools that mandatory in arriving at such corporate decisions. The primal objective of corporate finance is the maximization of corporate value by minimizing corporate risks. Every decision made in a business has financial implications, and any decision that involves the use of money is a corporate financial decision. Superior investment and financing decisions could put firms a step ahead of their competitors. However, a series of bad investment or financing decisions could cause undesirable damage. Firms have scarce resources that must be allocated among competing needs. The first and foremost function of corporate financial theory is to provide a framework for firms to make this decision wisely. Accordingly, the Investment Decisions include not only those that create revenues and profits (such as introducing a new product line or expanding into a new market) but also those that save money (such as building a new and more efficient distribution system). Furthermore, how much and what inventory to maintain and whether and how much credit to grant to customers that are categorized as working capital

2 decisions, are ultimately investment decisions as well. Todays capital investments generate future returns. Frequently, the returns come in the distant future. Thus, the management must pay attention to the timing of project returns, not just their cumulative amount. Every business, no matter how large and complex, is ultimately funded with a mix of borrowed money (debt) and owners funds (equity). At the other end of the spectrum, the Financing Decision includes not only choosing the right financing mix (debt and equity) that maximizes the value of the investments but also matching the financing to nature of the assets being financed. When a firm needs to raise money, it can invite investors to put up cash in exchange for a share of future profits (equity financing), or it can promise to pay back the investors cash plus a fixed rate of interest (debt financing). The choice between equity and debt financing is often called the Capital Structure Decision. In a normal business operation, the flow of cash between investors and the firms operations start when the cash is raised by issuing financial assets to investors in a form of a share of stock. The cash is used to pay for the real assets (tangible and intangible assets) needed for the firms operation. If the firm is doing well, the cash that is generated will either be reinvested or returned to the investors who provide the money. A corporation is a distinct, permanent legal entity that is owned by the stockholders, who elect a board of directors that make business decisions and oversee policies. Corporations are formed by submitting Articles of Incorporation

3 to the state in which the corporation is doing business and are taxed separately from their owners at the corporate tax rate. Because corporations are separate entities, the debts and liabilities of the corporations are also separate from those of the owners and can be settled only up to their share contribution. This separation is sometimes called a corporate shield because the shareholders cannot be sued individually for corporate wrongdoings. Since a corporation is treated as an independent entity, it does not cease to exist when its shareholders change or die. Almost every firm, government agency, and other type of organization employ one or more financial managers. Financial managers oversee the preparation of financial reports, direct investment activities, and implement cash management strategies. Managers also develop strategies and implement the long-term goals of their organization. The role of the financial manager, particularly in business, is changing in response to technological advances that have significantly reduced the amount of time it takes to produce financial reports. Technological improvements have made it easier to produce financial reports, and, as a consequence, financial managers now perform more data analysis that allows them to offer senior managers profit-maximizing ideas. They often work on teams, acting as business advisors to top management. The duties of financial managers vary with their specific titles, which include controller, treasurer, and chief financial officer. Controllers prepare the

4 financial statements; manage the firms internal budgets and accounting, and looks after its tax affairs. Treasurers is most directly responsible for looking after the firms cash, raising new capital, and maintaining relationships with banks and other investors who hold the firms securities. Chief Finance officers oversee both the treasurers and the controllers work. The CFO is deeply involved in financial policy making and corporate planning. He or she will have general responsibilities beyond strictly financial issues, and may join the companys board of directors. Theoretically, management is to have the business smarts to run a company in the interest of the owners. Of course, it is unrealistic to believe that management only thinks about the shareholders. Problems arise when the interests of the managers are different from the interests of the shareholders. The problem behind the tendency for this to occur is called Agency problems. These problems are kept in check by compensation plans that link the well-being of employees to that of the firm, monitoring of management by the board of directors, security analysts, and creditors, and by the threat of takeover. According to Theo Vermaelen, a Professor of Finance at INSEAD, Shareholder value is defined as the present value of free cash flows from now until infinity, discounted at a rate that reflects the risks of these cash flows. So, maximizing shareholder value is not the same thing as maximizing short-term profits, earnings per share or manipulating stock prices through accounting fraud.

5 The Enron disaster, in which all shareholders lost their money, has nothing to do with excessive focus on shareholder value," A strong management is the backbone of any successful company. This is not to say that employees are not also important, but it is management that ultimately makes the strategic decisions. Ethical decisions are value maximizing behavior. Ethical decision-making makes good business sense in the long run. Good ethical decisions will be rewarded and bad ethical decisions will be punished. Many businesses have gained a bad reputation just by being in business. To some people, businesses are interested in making money, and that is the bottom line. It could be called capitalism in its purest form. Making money is not wrong in itself. It is the manner in which some businesses conduct themselves that brings up the question of ethical behavior. In other words, it pays to do the right thing.

Chapter 2: Why Corporations Need Financial Markets and Institutions

Finance is the life blood of the business. It includes things related to lending, spending and saving money. Finance for a business can't be undervalued and can be said that it's the lifeline of a business and is required for its well-being. It can be said to be a lubricant which keeps the business running. Whether an individual have a small, medium or large business, he/she will always need finance, right from the beginning to promoting and establishing his/her product, acquiring assets, employ people, encouraging them to work for the development of his/her product and create a brand name. In addition to that, a current business may need finance for expansion or making changes to its products as per the market requirements. Financial Market is the market where financial securities like stocks and bonds and commodities like valuable metals are exchanged at efficient market prices. Here, by efficient market prices mean the unbiased price that reflects belief at collective speculation of all investors about the future prospect. The trading of stocks and bonds in the financial market can take place directly between buyers and sellers or by the medium of Stock Exchange. Financial Markets can be domestic or international. The financial market has sub-types such as: Primary markets which are the markets in which corporations raise new capital. The corporation selling the

7 newly created stock receives the proceeds from the sale in a primary market transaction; the initial public offering (IPO) market is a subset of the primary market. Here firms go public by offering shares to the public for the first time. In the majority of IPOs, the insiders sell some of their shares plus the company sells newly created shares to raise additional capital; Secondary markets are markets in which existing, already outstanding, securities that are traded among investors. The New York Stock Exchange is a secondary market, since they deal in outstanding, as opposed to newly issued, stocks; an Over-the-counter market has no centralized mechanism or facility for trading. Instead, the market is a public market consisting of a number of dealers spread across a region, a country, or indeed the world, who make the market in some type of asset. Many well-known common stocks are traded over-the-counter in the United States through NASDAQ (National Association of Securities Dealers' Automated Quotation System); fixed income market are market where securities that yield fixed income (bonds, preferred stock, and treasury bills) are bought and sold; the Capital market is the market for longer-term securities, generally those with more than one year to maturity; Money markets are the markets for short-term, highly liquid debt securities; The Foreign Exchange Market is the most liquid of the financial markets. Each country has its own national currency and each national currency has a value in relation to another national currency; The Commodities Market are the market in which commodities are generally raw physical products such as grains, metals or oil, which can be bought and sold depending on a persons outlook on the value of that commodity; Derivatives are securities

8 whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. Financial Intermediaries is an organization that accepts money from savers or investors and loans those funds to borrowers, thus providing a link between those seeking earnings on their funds and those seeking credit. Financial intermediaries include mutual funds and pension funds. Mutual funds are considered to be as an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. One of the main advantages of mutual funds is that they give small investors access

to professionally managed, diversified portfolios of equities, bonds and other securities, which would be quite difficult (if not impossible) to create with a small amount of capital. A Pension fund is established by an employer to facilitate and organize the investment of employees' retirement funds contributed by the employer and employees. The pension fund is a common asset pool meant to generate stable growth over the long term, and provide pensions for employees when they reach the end of their working years and commence retirement. They provide professional management and diversification. The contributions are tax-deductible, and investment returns are not taxed until cash is finally withdrawn. Financial Institutions are establishment that focuses on dealing with financial transactions, such as investments, loans and deposits. Conventionally,

9 financial institutions are composed of organizations such as banks, trust companies, insurance companies and investment dealers. Almost everyone has deal with a financial institution on a regular basis. Everything from depositing money to taking out loans and exchange currencies must be done through financial institutions. A bank is a financial institution and a financial intermediary that accepts deposits and channels those deposits into lending activities, either directly or through capital markets. A bank connects customers with capital deficits to customers with capital surpluses. Insurance companies are companies that offers insurance policies to the public, either by selling directly to an individual or through another source such as an employee's benefit plan. An insurance company can specialize in one type of insurance, such as life insurance, health insurance, or auto insurance, or offer multiple types of insurance. The major functions of financial markets and institutions in a modern financial system are: Transporting cash across time: Savers can save money now to be withdrawn and spent at a later time, while borrowers can borrow cash today, in effect spending today income to be earned in the future. Risk transfer and diversification: Insurance companies allow individuals and business firms to transfer risk to the insurance company, for a price. Financial institutions such as mutual funds allow an investor to reduce risk by diversification of the investors holdings.

10 Liquidity: Financial markets and institutions provide investors with the ability to exchange an asset for cash on short notice, with minimal loss of value. A deposit in a bank savings account earns interest, but can be withdrawn at almost any time. A share of stock in a publicly traded corporation can be sold at virtually any time. Payment mechanism: Financial institutions provide alternatives to cash payments, such as checks and credit cards. Information provided by financial markets: Financial markets reveal information about important economic and financial variables such as commodity prices, interest rates and company values (i.e., stock prices). The objective of value maximization makes sense for stockholders because this is the only task stockholders require of corporate management. In addition, the financial markets provide the pricing mechanism and the information stockholders require in order to assess the performance of the firms management in achieving this objective. The opportunity cost of capital is the expected rate of return offered by the best alternative investment opportunity. When the firm makes capital investments in behalf of the owners of the firm it must consider the shareholders other investment opportunities. The firm should not invest unless the expected return on investment at least equals the expected return the shareholders could obtain on their own by investing in the financial markets.


Chapter 3: Accounting and Finance

A balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is a snapshot of a business financial condition at a specific moment in time, usually at the close of an accounting period. A balance sheet comprises assets, liabilities, and owners or stockholders equity. The main categories of assets are usually listed first and typically in order of liquidity. Assets are subdivided into current and non-current assets to reflect the ease of liquidating each asset. Cash, for obvious reasons, is considered the most liquid of all assets. Current assets are any assets that can be easily converted into cash within one calendar year. Examples of current assets would be checking or money market accounts, accounts receivable, and notes receivable that are due within one years time. Non-current assets are assets that are not turned into cash easily, are expected to be turned into cash within a year and/or have a lifespan of more than a year. They can refer to tangible assets such as machinery, computers, buildings and land. Non-current assets also can be intangible assets, such as goodwill, patents or copyright. On the other side of the balance sheet are the liabilities. These are the financial obligations a company owes to outside parties. Like assets, they can be both current and non-current. Non-current liabilities are debts and other non-debt financial obligations, which are due after a

12 period of at least one year from the date of the balance sheet. Current liabilities are the companys liabilities which will come due, or must be paid, within one year. This is includes both shorter term borrowings, such as accounts payables, along with the current portion of longer term borrowing, such as the latest interest payment on a 10-year loan. Shareholders' equity is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholders equity account. This account represents a company's total net worth. At any given time, assets must equal liabilities plus shareholders equity. In the equation, it shows how assets were financed: either by borrowing money (liability) or by using the owner's money (owner's equity). Balance sheets are usually presented with assets in one section and liabilities and stockholders equity in the other section with the two sections "balancing." Book value is the net worth of the firm according to the balance sheet. It can be useful for individuals considering whether to purchase a stock. The book value is the amount that would potentially be divided among the stock holders should the company be liquidated. More definitely, it can be used as an indicator of whether the stock is over or under valued in the market. The need for book value arises when it comes to generally accepted accounting principles. According to these rules, hard assets (like buildings and equipment) listed on a company's balance sheet can only be stated according to book value.

13 Market value is the current quoted price at which investors buy or sell a share of common stock or a bond at a given time. Most investors who use fundamental analysis to pick stocks look at a company's market value and then determine whether or not the market value is adequate or if it's undervalued in comparison to its book value, net assets or some other measure. Market value and book value are interrelated and useful in gathering a complete picture of any company. Knowledge of both and their influence on each other in any company and in any situation can be helpful when planning investments. If a Balance Sheet is like a picture, a snapshot of a point in time, then the Income Statement is like a video. It shows us what went on in the business over a period of time, usually a month, quarter or year. The Income Statement's job is to show a breakdown, by category, of how the equity in the company changed as a result of doing business that period. It shows that either the company made money, which increases equity, or it lost money, which decreases equity. It is based on a fundamental accounting equation (Income = Revenue - Expenses) and shows the rate at which the owners equity is changing for better or worse. Firms use an income statement to track revenues and expenses so that they can determine the operating performance of their business over a period of time. Business owners use these statements to find out what areas of their business are over budget or under budget. To a serious investor, income statement analysis reveals much more than a company's earnings. It provides important insights into how effectively management is controlling expenses, the amount of

14 interest income and expense, and the taxes paid. Investors can use income statement analysis to calculate financial ratios that will reveal the rate of return the business is earning on the shareholders' retained earnings and assets. In other words, how well they are investing the money under their control. They can also compare a company's profits to its competitors by examining various profit margins such as the gross profit margin, operating profit margin, and net profit margin. The cash flow statement (CFS), a mandatory part of a company's financial reports, records the amounts of cash and cash equivalents entering and leaving a company. The CFS allows investors to understand how a company's operations are running, where its money is coming from, and how it is being spent. The statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. It excludes transactions that do not directly affect cash receipts and payments. These non-cash transactions include depreciation or write-offs on bad debts or credit losses. The cash flow statement is a cash basis report on three types of financial activities: operating activities, investing activities, and financing activities. Operating activities include the day-to-day operations. Increases and decreases in receivables and payables are accounted for on the cash flow statement, as are other activities from operating the business and selling the products and services. The operating section is where the main cash flow should be generated. Long-term business health comes from having a good net profit and positive cash flow from the operating activities. Investing activities include the

15 purchase and sale of the long-term fixed assets, such as property, plant and equipment. Financing activities include the borrowing and repayment of longterm liabilities. Taxes frequently have a significant impact on financial decisions. Corporate tax is a tax that must be paid by a corporation based on the amount of profit generated. The amount of tax, and how it is calculated, varies depending upon the region where the company is located. It is common to say that the corporate tax rate is 35%, but the rate varies from 15% to 35%, depending on the amount of corporate income subject to tax for the year. Personal Tax is a progressive or graduated tax - it increases as a percentage of income as your income gets larger. It is a tax paid on one's personal income as distinct from the tax paid on the firm's earnings. In an incorporated firm, the owners (shareholders) pay taxes on both their income (salary or dividend from the firm) firm's income (profits). In partnerships and sole-ownerships, the tax is paid only once on the firm's profits. Marginal tax rate is the amount of tax paid on an additional dollar of income. As income rises, so does the tax rate. For example, the income you earn from investments is added to your income from all other sources. As a result, each additional dollar of investment income is taxed at the highest rate applicable to your total income. The average tax rate is calculated by dividing the total income taxes paid by the total income. The average tax rate incorporates taxes paid at all levels of income so naturally it will be less than the marginal rate.