UCSB ECON 134A: Introductory Finance

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UCSB ECON 134A Introductory Finance
Lecture 1 Introduction to Corporate Finance

• Spring quarter 2009
• Instructor Ragnar Arnason

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The Company

• An organization set up to accomplish a purpose
• Usually a legal entity (i.e. in accordance with
  law)
• ? There is an owner
• The purpose is usually to make profits (a
  business organization)
• Non-profit organizations exist

In this course Concerned with business
organizations
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Types of Business Organizations

• The Sole Proprietorship
• The Partnership
• General Partnership
• Limited Partnership
• The Corporation (limited company)

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Comparing corporations and partnerships
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Company objectives

• Maximize benefits to the owners
• These benefits are usually profits
• But they can be other things
• Size
• Growth
• Power
• Forces of competition tend to force companies to
  be profit maximizing!

In this course Assume profit maximization
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Profit maximization ? Maximization of the value
of the company
Why?
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Principal-agent problems

• It is not clear that company employees will
  necessarily do what the owner wants
• They will want to maximize their own benefits
• Little work, high payment, security
• Managers have considerable room to do this
• High salary, bonuses, job security, little
  responsibility etc.
• This causes a problems for owners
• More pronounced in large companies

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Three measures of company outcomes

• Balance sheet
• Snapshot of the financial status of the company
• Income statement Profits and loss account
• Accumulated flow of profits/losses over a period
  of time (year/quarter)
• Cash flow Statement of cash flow
• Accumulated flow of cash over a period of time
  (year/quarter)

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Profits and Cash Flow

• Profits are not cash flows
• Include many noncash items (unpaid sales,
  depreciation, asset value gains etc.)
• Profits are only useful if they can be
  transformed into cash
• All profits and losses must ultimately be
  represented by a flow of cash
• The cash flow is the ultimated measure
• In the long run cash flows and profits converge

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Generation of cash Main items

• In
• Operational receipts less outlays
• Borrowings
• Owners contributions
• Out
• Investments
• Payments of loans
• Payment of taxes
• Payment to owners

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What is Corporate Finance?

• Corporate Finance is a business management
  function which deals (primarily) with the
  following problems
• What long-term investments should the firm
  choose? (The capital budgeting decision)
• How should the firm raise funds for the selected
  investments? (The capital structure decision)
• How should short-term assets be managed and
  financed? (Short term asset management)

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Other important business management functions

• Top level
• Chief Executive Officer (CEO)
• Second level
• Production management
• Marketing (sales) management
• Others depending on the nature of the business

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Typical company organizational chart
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Typical Firm Balance sheet
Assets
Liabilities
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Task 1The Capital Budgeting Decision
Current Liabilities
Current Assets
Long-Term Debt
Fixed Assets 1 Tangible 2 Intangible
Shareholders Equity
What long-term investments should the firm choose?
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Task 2The Capital Structure Decision
Current Liabilities
Current Assets
Long-Term Debt
How should the firm raise funds for the selected
investments?
Fixed Assets 1 Tangible 2 Intangible
Shareholders Equity
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Task 3Short term asset management
Current Liabilities
Current Assets
Net Working Capital
Long-Term Debt

• How should short-term assets be managed and
  financed?

How should short term assets be managed and
financed
Fixed Assets 1 Tangible 2 Intangible
Shareholders Equity
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How can the financial manager contribute to
companys profits?

• All three major functions are of great importance
  for profits
• Choosing the right investment is crucial in the
  long term (Too many wrong investments and the
  company is dead)
• The way the company is financed can make a
  great deal of difference (Example banks lately).
• Managing the liquidity (short term assets) is
  also important (Can avoid insolvency)

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The Firm and the Financial Markets
Cash in Firm issues securities
Retained cash flows (F)
Cash flowfrom firm (C)
Dividends anddebt payments (E)
Short-term debt Long-term debt Equity shares
Current assetsFixed assets
Taxes (D)
The cash flows from the firm must exceed the cash
flows from the financial markets.
Ultimately, the firm must be a cash generating
activity.
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Financial Markets

• Primary Market
• Issuance of a security by a company
• Secondary Markets
• Buying and selling of previously issued
  securities
• Securities may be traded in either a dealer or
  auction market
• NYSE, NASDAQ, etc.

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Financial Markets
Investors
Firms
Sue
Bob
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Goal of the financial manager
Adjust company finances to Maximize the value of
the company