Week 1: Chapter 1 & 2
Topics
● A key concept in finance
● Chapter 1: Corporate Finance & the Financial Manager
● Chapter 2: Introduction to Financial Statement Analysis
A Key Concept in Finance
● An Example
➔ Suppose you were given the choices between receiving $1,000 today or $1,000
in 10 years. Which option would you prefer?
● The essence: Time Value of Money
➔ More is better, sooner is better, and less risky is better
● Application
➔ Valuation of stock and bond
➔ Making capital investment decisions
➔ Calculation of pension and mortgage
Chapter 1
● Types of Firms
● Taxes
● What is Corporate Finance?
● Role of the Financial Manager
● Goals of the Corporation
● Agency Problem
● Financial Markets
Types of Firms
Sole Proprietorship
➔ One individual owns and manages the business
➔ Bears all the costs, but keep all of the profits
➔ No separation of business and individual
● Advantages
➔ Ease of establishment and lack of regulation
● Disadvantages
➔ Unlimited liability – that individual is personally liable for all of the firm’s liabilities
(financial and legal)
➔ Limited life
➔ Difficult to transfer ownership
Partnership
➔ Partnerships can be organized as general partnerships or limited partnerships.
➔ Income from the partnership is taxed at the personal level.
➔ The income is split among partners according to their ownership in the partnership
Types of Partnership
➔ General partnership (only general partners, similar to sole proprietorship)
➔ Limited partnership (general partners and limited partners)
➔ Limited liability partnership (LLP) in Canada
,Corporation
➔ A business which is legally separate from its owners, who are called shareholders.
➔ The entire ownership stake of a corporation is divided into shares known as stock.
● Advantages
➔ Limited liability (financial and legal)
➔ More flexible & permanent (managers and shareholders come and go, firm
remains)
● Disadvantages
➔ Taxation (firm profits + dividends to tax payers)
➔ Agency Issues (more later)
➔ Regulations and costs
What is Corporate Finance?
● What long-term investments should you take on?
➔ Capital budgeting
➔ E.g. Apple developed IPhone, Google purchased YouTube
● Where will you get the long-term financing to pay for your investment?
➔ Capital structure
➔ E.g. IPOs, seasoned equity offerings, bank debts
● How will you manage day-to-day financial activities?
➔ Working capital management
➔ E.g. collecting from customers, paying suppliers
Role of the Financial Manager
Goals of the Corporation
● The goal of any corporation is to maximize shareholder wealth
➔ Increasing market value increases shareholder wealth.
➔ Thus, the objective is to maximize current share price.
➔ But not at the cost of unethical behavior! (e.g. Enron, WorldCom).
● How to maximize shareholder wealth?
➔ To improve a firm’s ability to generate Cash Flows now and in the future
Agency Problems
● Agency Problems
➔ Resulting from the separation of management and ownership
, ➔ Conflicts of interest between the firm’s owners (principals) and its managers
(agents)
● Can be reduced in several ways:
➔ Compensation plans: firm stock and options
➔ Board of Directors
➔ Threat of takeovers
➔ Specialist monitoring
Financial Markets
● Financial Assets/Securities
➔ Financial assets vs. real assets
➔ A security is a legal contract between the firm and its investors.
➔ It represents a claim on the firm’s real assets and the cash those assets will
produce
● Financial Markets
➔ Market where securities are issued and traded
➔ Stock market vs. fixed-income (bond) market
➔ Exchanges vs. over-the-counter
Chapter 2
● Statement of Financial Position / Balance Sheet
● Statement of Comprehensive Income / Income Statement
● Cash Flow
● Statement of Cash Flows (Accounting)
● Cash Flow Identity (Finance)
● Financial Statement Analysis
Balance Sheet
● Also referred to as Statement of Financial Position
● Shows the value of the firm’s assets and liabilities at a particular time
➔ A snapshot (e.g. as of Dec 2020)
➔ What a firm owns – the firm’s assets
➔ Where the money to buy those assets came from – the firm’s liabilities plus the
firm’s shareholders’ equity
, ● 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
● Debt vs Equity
➔ Creditors have the first claim on firm’s CF and assets.
➔ Equity holders are entitled to the residual CF and asset value.
➔ The more debt a firm has the greater its degree of financial leverage.
➔ Financial leverage magnifies both gains and losses to shareholders.
● Book Value does not equal to Market Value
➔ Assets are recorded on the Balance Sheet at their historic cost.
➔ Historic cost less accumulated depreciation (wear and tear) is known as the book
value of the asset.
➔ Assets belonging to the firm may be resold in the market.
➔ The price at which the firm can resell an asset is known as its market value.
➔ Market value represents the future of the assets, not the past
● Market-to-Book Ratio
● Net Working Capital
➔ Measures ability to meet cash obligations over the next 12 months
➔ Net Working Capital = Current Assets – Current Liabilities
➔ Usually positive in a healthy firm
● Enterprise Value
➔ Assesses the value of the underlying business assets
➔ The total market value of a firm’s equity and debt, less the value of its cash and
marketable securities
➔ Enterprise Value = Market Value of Equity + Debt − Cash
Income Statement
● Also referred to as Statement of Comprehensive Income
● Shows the revenues, expenses and net income of a firm over a period of time
➔ A video recording (e.g. for year 2020)
Topics
● A key concept in finance
● Chapter 1: Corporate Finance & the Financial Manager
● Chapter 2: Introduction to Financial Statement Analysis
A Key Concept in Finance
● An Example
➔ Suppose you were given the choices between receiving $1,000 today or $1,000
in 10 years. Which option would you prefer?
● The essence: Time Value of Money
➔ More is better, sooner is better, and less risky is better
● Application
➔ Valuation of stock and bond
➔ Making capital investment decisions
➔ Calculation of pension and mortgage
Chapter 1
● Types of Firms
● Taxes
● What is Corporate Finance?
● Role of the Financial Manager
● Goals of the Corporation
● Agency Problem
● Financial Markets
Types of Firms
Sole Proprietorship
➔ One individual owns and manages the business
➔ Bears all the costs, but keep all of the profits
➔ No separation of business and individual
● Advantages
➔ Ease of establishment and lack of regulation
● Disadvantages
➔ Unlimited liability – that individual is personally liable for all of the firm’s liabilities
(financial and legal)
➔ Limited life
➔ Difficult to transfer ownership
Partnership
➔ Partnerships can be organized as general partnerships or limited partnerships.
➔ Income from the partnership is taxed at the personal level.
➔ The income is split among partners according to their ownership in the partnership
Types of Partnership
➔ General partnership (only general partners, similar to sole proprietorship)
➔ Limited partnership (general partners and limited partners)
➔ Limited liability partnership (LLP) in Canada
,Corporation
➔ A business which is legally separate from its owners, who are called shareholders.
➔ The entire ownership stake of a corporation is divided into shares known as stock.
● Advantages
➔ Limited liability (financial and legal)
➔ More flexible & permanent (managers and shareholders come and go, firm
remains)
● Disadvantages
➔ Taxation (firm profits + dividends to tax payers)
➔ Agency Issues (more later)
➔ Regulations and costs
What is Corporate Finance?
● What long-term investments should you take on?
➔ Capital budgeting
➔ E.g. Apple developed IPhone, Google purchased YouTube
● Where will you get the long-term financing to pay for your investment?
➔ Capital structure
➔ E.g. IPOs, seasoned equity offerings, bank debts
● How will you manage day-to-day financial activities?
➔ Working capital management
➔ E.g. collecting from customers, paying suppliers
Role of the Financial Manager
Goals of the Corporation
● The goal of any corporation is to maximize shareholder wealth
➔ Increasing market value increases shareholder wealth.
➔ Thus, the objective is to maximize current share price.
➔ But not at the cost of unethical behavior! (e.g. Enron, WorldCom).
● How to maximize shareholder wealth?
➔ To improve a firm’s ability to generate Cash Flows now and in the future
Agency Problems
● Agency Problems
➔ Resulting from the separation of management and ownership
, ➔ Conflicts of interest between the firm’s owners (principals) and its managers
(agents)
● Can be reduced in several ways:
➔ Compensation plans: firm stock and options
➔ Board of Directors
➔ Threat of takeovers
➔ Specialist monitoring
Financial Markets
● Financial Assets/Securities
➔ Financial assets vs. real assets
➔ A security is a legal contract between the firm and its investors.
➔ It represents a claim on the firm’s real assets and the cash those assets will
produce
● Financial Markets
➔ Market where securities are issued and traded
➔ Stock market vs. fixed-income (bond) market
➔ Exchanges vs. over-the-counter
Chapter 2
● Statement of Financial Position / Balance Sheet
● Statement of Comprehensive Income / Income Statement
● Cash Flow
● Statement of Cash Flows (Accounting)
● Cash Flow Identity (Finance)
● Financial Statement Analysis
Balance Sheet
● Also referred to as Statement of Financial Position
● Shows the value of the firm’s assets and liabilities at a particular time
➔ A snapshot (e.g. as of Dec 2020)
➔ What a firm owns – the firm’s assets
➔ Where the money to buy those assets came from – the firm’s liabilities plus the
firm’s shareholders’ equity
, ● 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
● Debt vs Equity
➔ Creditors have the first claim on firm’s CF and assets.
➔ Equity holders are entitled to the residual CF and asset value.
➔ The more debt a firm has the greater its degree of financial leverage.
➔ Financial leverage magnifies both gains and losses to shareholders.
● Book Value does not equal to Market Value
➔ Assets are recorded on the Balance Sheet at their historic cost.
➔ Historic cost less accumulated depreciation (wear and tear) is known as the book
value of the asset.
➔ Assets belonging to the firm may be resold in the market.
➔ The price at which the firm can resell an asset is known as its market value.
➔ Market value represents the future of the assets, not the past
● Market-to-Book Ratio
● Net Working Capital
➔ Measures ability to meet cash obligations over the next 12 months
➔ Net Working Capital = Current Assets – Current Liabilities
➔ Usually positive in a healthy firm
● Enterprise Value
➔ Assesses the value of the underlying business assets
➔ The total market value of a firm’s equity and debt, less the value of its cash and
marketable securities
➔ Enterprise Value = Market Value of Equity + Debt − Cash
Income Statement
● Also referred to as Statement of Comprehensive Income
● Shows the revenues, expenses and net income of a firm over a period of time
➔ A video recording (e.g. for year 2020)
