Organizing a Business

1
Introduction

• Organizing a Business
• The Role of The Financial Manager
• Financial Markets
• Corporate Goals Incentives

2
Organizing a Business

• Types of Business Organizations
• Sole Proprietorships
• Partnerships
• Corporations
• Hybrids
• Limited Partnerships
• LLP
• LLC
• PC

3
Organizing a Business
4
The Role of The Financial Manager
Financial
Firm's
Financial
managers
operations
markets
5
Financial Markets
Company
Intermediary
Investor
6
The Role of The Financial Manager

• Investment Decisions
• Capital Budgeting
• Buy real assets that are worth more than they
  cost
• Financing Decisions
• Source of Funds Capital Markets
• Capital Structure

7
Advantages of Intermediation

• 1 Transaction costs/Payments mechanisms.
• 2 Matching borrowers and lenders
• Borrower may want to borrow for 2 years
• May have many lenders that want to lend for a
  year each.
• 3 Pooling of Risk

8
Goals of The Corporation

• Shareholders desire wealth maximization
• Do managers maximize shareholder wealth?
• Managers have many constituencies stakeholders
• Agency Problems represent the conflict of
  interest between management and owners

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Goals of The Corporation
Agency Problem Solutions 1 - Compensation
plans 2 - Board of Directors 3 - Takeovers 4 -
Specialist Monitoring 5 Auditors Remark
Problems can still occur because of differences
of information.
10
Financial Accounting

• The Balance Sheet
• The Income Statement
• The Statement of Cash Flows
• Accounting for Differences
• Taxes

11
The Balance Sheet
Definition Financial statements that show the
value of the firms assets and liabilities at a
particular point in time (from an accounting
perspective).
12
The Balance Sheet
The Main Balance Sheet Items
Current Assets Cash Securities Receivables I
nventories Fixed Assets Tangible
Assets Intangible Assets
13
The Balance Sheet
The Main Balance Sheet Items
Current Liabilities Payables Short-term
Debt Long-term Liabilities Shareholders
Equity
Current Assets Cash Securities Receivables I
nventories Fixed Assets Tangible
Assets Intangible Assets

14
Market Value vs. Book Value
Book Values are determined by GAAP Market
Values are determined by current values Equity
and Asset Market Values are usually higher than
their Book Values
15
Market Value vs. Book Value
Example According to GAAP, your firm has equity
worth 6 billion, debt worth 4 billion, assets
worth 10 billion. The market values your firms
100 million shares at 75 per share and the debt
at 4 billion. Q What is the market value of
your assets?
16
Market Value vs. Book Value
Example According to GAAP, your firm has equity
worth 6 billion, debt worth 4 billion, assets
worth 10 billion. The market values your firms
100 million shares at 75 per share and the debt
at 4 billion. Q What is the market value of
your assets?
A Since (AssetsLiabilities Equity), your
assets must have a market value of 11.5 billion.
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Market Value vs. Book Value
Example (continued) Book Value Balance
Sheet Assets 10 bil Debt 4
bil Equity 6 bil
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Market Value vs. Book Value
Example (continued) Book Value Balance
Sheet Assets 10 bil Debt 4
bil Equity 6 bil Market Value Balance
Sheet Assets 11.5 bil Debt 4
bil Equity 7.5 bil
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The Income Statement
Definition Financial statement that shows the
revenues, expenses, and net income of a firm over
a period of time (from an accounting
perspective).
20
The Income Statement
Earnings Before Interest Taxes (EBIT) EBIT
total revenues minus costs minus
depreciation
21
The Income Statement
Pepsico Income Statement (year end 1998) Net
Sales 22,348 COGS 9,330 Other
Expenses 291 Selling, GA
expenses 8,912 Depreciation expense
1,234 EBIT 2,581 Net interest expense
321 Taxable Income 2,260 Income Taxes
270 Net Income 1,990
22
Profits vs. Cash Flows

• Differences
• Profits subtract depreciation (a non-cash
  expense)
• Profits ignore cash expenditures on new capital
  (the expense is capitalized)
• Profits record income and expenses at the time
  of sales, not when the cash exchanges actually
  occur
• Profits do not consider changes in working
  capital

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The Statement of Cash Flows
Pepsico Statement of Cash Flows (excerpt - year
end 1998) Net Income 1,990
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The Statement of Cash Flows
Pepsico Statement of Cash Flows (excerpt - year
end 1998) Net Income 1,990 Non-cash
expenses Depreciation 1,234 Other
382 Changes in working capital A/R(303)
A/P253 Inv(284) other(47) (381) Cash Flow
from Operations 3,212
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The Statement of Cash Flows
Pepsico Statement of Cash Flows (excerpt - year
end 1998) Net Income 1,990 Non-cash
expenses Depreciation 1,234 Other
382 Changes in working capital A/R(303)
A/P253 Inv(284) other(47) (381) Cash Flow
from Operations 3,212 Cash Flow for New
Investments (5,019) Cash Raised by New
Financing 190 Net Change in Cash Position
(1,617)
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Taxes

• Taxes have a major impact on financial decisions
• Marginal Tax Rate is the tax that the individual
  pays on each extra dollar of income.
• Average Tax Rate is the total tax bill divided by
  total income.

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Taxes
Example - Taxes and Cash Flows can be changed by
the use of debt. Firm A pays part of its profits
as debt interest. Firm B does not.
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Taxes
Example - Taxes and Cash Flows can be changed by
the use of debt. Firm A pays part of its profits
as debt interest. Firm B does not. Firm
A EBIT 100 Interest 40 Pretax Income
60 Taxes (35) 21 Net Income 39
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Taxes
Example - Taxes and Cash Flows can be changed by
the use of debt. Firm A pays part of its profits
as debt interest. Firm B does not. Firm
A Firm B EBIT 100 100 Interest 40
0 Pretax Income 60 100 Taxes (35) 21
35 Net Income 39 65
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Taxes
FOOD FOR THOUGHT - If you were both the debt and
equity holders of the firm, which would generate
more cash flow to you? (assume Net Income Cash
Flow) Firm A Firm B Net Income 39 65
Interest 40 0 Net Cash Flow 79 65
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Why the difference?

• Firm A Firm B
• Net Income 39 65
• Interest 40 0
• Net Cash Flow 79 65
• Interest is not taxed!
• 400.3514 (which is the difference)

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