Chapter 1 Summary

Course Introduction to FIN-320: Financial Management I

Instructor Information

Professor: Kelly Ko, CFA
- Background:
  - Joined California State University, Fullerton (CSUF) in August $2017$ .
  - Previously had a $31$ -year career as an Institutional Equity Portfolio Manager and Equity Securities Analyst.
  - Managed large, mid, and small cap value portfolios and mutual funds.
  - At CSUF, directs both the Student Managed Investment Fund (SMIF) and Titan Capital Management (TCM) Equity programs.
  - Mentors students pursuing the CFA designation.
  - Chairs the CFA scholarship committee and program affiliation with the CFA Institute.
  - Earned Chartered Financial Analyst (CFA) designation in $1997$ .
  - Holds an MBA from Duke University and a BS in Finance from the University of Southern California.
  - Interests: Tennis, College Sports, Les Paul Guitars, Mazda RX-7’s, Chess, and Video Gaming.
Office: SGMH $2317$ (TCM Investment Research Center, $2$ nd Floor)
Email: keko@fullerton.edu
Sections: ## $15$ ( $12681$ ) and ## $40$ ( $12075$ )
SI Leaders: Ladi Trejo (Section $15$ ), Nirvan Chitnis (Section $40$ )
- Session times: To Be Announced (TBA)
Meetings:
- $8:30$ am - $9:45$ am, T-TH in SGMH $1307$
- $1:00$ pm - $2:15$ pm, T-TH in SGMH $2307$
Office Hours: Tuesday-Thursday: $10$ am - $11:30$ am, or by scheduled appointment via Zoom.
- Students with advance appointments will have priority.

Required Course Materials

Required Text:
- Fundamentals of Corporate Finance, Custom Edition for Finance $320$ , CSUF, by Berk, DeMarzo and Harford. Pearson Custom Publishing.
- Students must purchase the package that includes MyFinanceLab.
- Registration instructions are available on Canvas.
Financial Calculator:
- HP-10b II+ is the required model.
- The instructor will use this calculator in class; students choosing a different calculator are responsible for learning its operation.
MyFinanceLab:
- Computerized online homework software package and e-book.
- Required for purchase and use.
- Price is approximately $75$ if purchased directly from Pearson using Canvas instructions.

Course Evaluation

Homework Assignments: $15$
- Completed on MyFinanceLab.
$2$ Midterm Exams: $40$
- $20$ \% each.
- Administered in class.
Valuation Exam: $15$
- Administered on MyFinanceLab.
Comprehensive Final Exam: $30$
- Covers Chapters $1, 2, 3, 4, 5, 6, 7, 8, 9, 11, 12, ext{and } 13$ .
Total: $100$

Grading Policy

Syllabus Changes: Changes may occur during the term; students are responsible for being aware of these by attending class.
Grading Scale: Plus/minus grading will be used.
- A letter grade of C or better is required to pass the course.
- A C- or below will result in failing the course, requiring a retake.
- Individual exams and assignments are not curved.
- Final grades consider the total body of work and overall class performance, but a curve is not guaranteed.
- Students should expect to earn grades within the published ranges and not rely on end-of-semester grade negotiations, as fairness requires any offerings to be available to all students.
Grade Percentages:
- A+: $4.0$ GPA, $98-100$ \%
- A: $4.0$ GPA, $94-97.99$ \%
- A-: $3.7$ GPA, $90-93.99$ \%
- B+: $3.3$ GPA, $88-89.99$ \%
- B: $3.0$ GPA, $84-87.99$ \%
- B-: $2.7$ GPA, $80-83.99$ \%
- C+: $2.3$ GPA, $78-79.99$ \%
- C: $2.0$ GPA, $74-77.99$ \%
- C-: $1.7$ GPA, $70-73.99$ \%
- D+: $1.3$ GPA, $68-69.99$ \%
- D: $1.0$ GPA, $64-67.99$ \%
- D-: $0.7$ GPA, $60-63.99$ \%
- F: $0.0$ GPA,
  $\lt 60$ \%

Homework and Extra Credit

Homework Assignments:
- $12$ weekly homework assignments.
- All $12$ assignments count toward the grade.
- Must register for MyFinanceLab via Canvas link within the first $3$ weeks of class; failure to do so results in losing the $15$ \% homework grade.
- Assignments have deadlines based on class material but can be submitted after the deadline.
- Suggestion: Complete before the deadline, then re-do to improve scores and practice; these are considered "free points."
- All assignments must be completed by the final exam date.
Extra Credit:
- Occasionally, additional practice problems may be assigned as extra credit to prepare for exams.
- Extra credit problems are not graded but can help move up a grade by $1$ \% on the weighted score at the end of the semester if all are completed.
- There are usually $7$ extra credit problems.
- Extra credit is "all or nothing"; all problems must be completed and submitted on Titanium links to receive credit.

Exams and Course Policies

Valuation Exam:
- Departmental requirement.
- Administered through MyFinanceLab.
- Students are allowed $2$ attempts, with the best grade recorded.
- Information about this exam is in the "Guide to Finance $320$ " section of the textbook.
Exam Aids:
- A formula sheet will be provided for exams.
- Students are allowed to bring one two-sided sheet of handwritten notes to exams.
Make-up Exams:
- Generally not given.
- Valid excuses (typed, signed, and verified) for missed exams will be considered.
- Students are responsible for taking exams on the scheduled dates, even if dates change from the syllabus.
- Exams must be taken with the section in which the student is enrolled.
Withdrawal: Dates and terms are as outlined by CSUF in the Course Schedule.
Student ID: CSUF student ID must be displayed during all exams.
- Exams are only given to enrolled students who show a valid picture ID.
Academic Dishonesty:
- Defined by University policy in the CSUF Catalog.
- Results in appropriate University-level disciplinary and academic action.
- Department of Finance policy requires an F grade for academic dishonesty.
- All individuals engaging in academic dishonesty will be reported to the Vice President, Student Affairs.
- Examples include taking credit for non-original work, looking at other students' work, passing answers, or using unauthorized notes.
- Identical answers, especially identical mistakes, between adjacent students may indicate academic dishonesty.

Course Schedule Overview (Tentative)

Week 8/22$ (Chapter 1 $): Corporate Finance and the Financial Manager (HW$ 1 $)</li><li>Week$ 8/29$ (Chapter $2$ ): Introduction to Financial Statement Analysis (HW $2$ )
Week 9/5$ (Chapter 3 $): Time Value of Money: An Introduction (HW$ 3 $)</li><li>Week$ 9/12$ (Chapter $4$ ): Time Value of Money: Valuing Cash Flow Streams (HW $4$ )
Week 9/19$: Exam I Review (Chapters 1-4 $)</li><li>Thursday,$ 9/21$: Exam I (In Class)
Week 9/26$ (Chapter 5 $): Interest Rates (HW$ 5 $)</li><li>Week$ 10/3$ (Chapter $6$ ): Bonds (HW $6$ )
Week 10/10$ (Chapter 7 $): Stocks (HW$ 7 $)</li><li>Week$ 10/17$ (Chapter $8$ ): Investment Decision Rules (HW $8$ )
Week 10/16$ (on Canvas): Sample Valuation Exam Available in MyLab
Week 10/22$: Problem Review Sample Valuation Exam (Chapters $3, 4, 6, 7$ , Sample Val Exam)
Week 10/24$: Valuation Exam Available Through MyLab (Due 10/29 $at$ 11:59 $pm!)</li><li>Week$ 10/31$ (Chapter $9$ ): Fundamentals of Capital Budgeting (HW $9$ )
Week 11/7$: Fundamentals of Capital Budgeting & Exam Review
Week 11/9$: Exam II Review
Thursday, 11/9$: Exam II (In Class)
Week 11/14$ (Chapter 11 ext{ and } 12 ext{ partial}$): Risk and Return / Systematic and Unsystematic Risk (HW 11 $)</li><li>Week$ 11/21$: Fall Recess (Thanksgiving)
Week 11/28$ (Chapter 12 ext{ and } 13 ext{ partial}$): Systematic Risk and the Equity Risk Premium / Systematic Risk / The Cost of Capital (HW $12$ , HW $13$ )
Week 12/5$: Final Exam Review (Canvas Mock Exams/Video)
Week 12/12$: Final Exam Week
- Section 40$ (Tuesday, Dec. 12, 2023$): $1$ pm - $2:50$ pm in SGMH $2307$
- Section 15$ (Thursday, Dec. 14, 2023$): $9$ am - $10:50$ am in SGMH $1307$
- The Final Exam is a common departmental exam.

Chapter 1: Corporate Finance and the Financial Manager

Why Study Finance?

Personal Finance Decisions: Individuals are increasingly managing their own finances.
- When to start saving and how much to save for retirement.
- Whether a car loan or lease is more advantageous.
- Evaluating a particular stock as an investment.
- Assessing the terms of a home mortgage.
- (Missing from the list provided: Other major personal financial planning elements like insurance, budgeting, estate planning).
Business Career Decisions: Financial understanding is crucial in various corporate roles.
- Deciding whether a firm should launch a new product.
- Selecting the best supplier for the firm.
- Determining whether to produce a part in-house or outsource production.
- Choosing between issuing new stock or borrowing money for funding.
- Strategizing how to raise money for a start-up firm.

The Four Types of Firms

Corporate finance involves understanding different organizational structures.

1. Sole Proprietorships

Advantages:
- Straightforward and easy to establish.
- Most common form of business formation.
Disadvantages:
- No separation between the firm and the owner: The owner is the business entity.
- Can only have one owner.
- Unlimited personal liability for the firm’s debts.
- Limited life; the business typically ends with the life of the owner.
- Difficult to transfer ownership.
- Limited access to capital.

2. Partnerships

Similar to sole proprietorships but with more than one owner.
Liability: All partners are liable for the firm’s debt; a lender can require any partner to repay all outstanding debts.
Life: The partnership typically ends upon the death or withdrawal of any single partner.
- Liquidation can be avoided if the partnership agreement includes alternatives (e.g., a buyout clause for deceased/withdrawn partners).
Limited Partnership (LP): A special type with two categories of owners.
- General Partners: Have unlimited liability and full management rights and privileges, similar to a general partnership.
- Limited Partners: Have limited liability (up to the amount of their investment) and transferable ownership but no management authority.

3. Limited Liability Companies (LLC)

Combines features of partnerships and corporations.
No general partner.
All owners have limited liability.
Owners can actively run the business.
Can also have non-managing partners.

4. Corporations

Key Concept: A corporation is a legally defined, artificial being, separate from its owners.
- Possesses many legal powers of a person: can enter contracts, acquire assets, incur obligations, and enjoys U.S. Constitutional protection against property seizure.
Advantages:
- Limited Liability for Owners: The corporation is solely responsible for its obligations.
  - Owners are not liable for corporate obligations.
  - The corporation is not liable for owners' personal obligations.
- Unlimited Owners: No limit on the number of owners.
- Divisibility of Ownership: Entire ownership is divided into shares (stock), collectively known as the equity of the corporation.
- Unlimited Life: Can have an unlimited life, independent of its owners.
- Easier Access to Capital: Easier to raise capital compared to other business forms.
- Shareholder Rights: Owners (shareholders, stockholders, equity holders) are entitled to dividend payments, typically proportional to their stock ownership.
- Separation of Ownership and Management: Owners are shareholders, but managers (CEO, CFO, COO) may not be owners, or own only small percentages in large corporations. This separation can lead to Agency Issues.
Disadvantages:
- Costly and Complex Formation: Must be legally formed and chartered in the state of incorporation.
  - A corporate charter specifies the initial rules.
  - More costly and less easy to set up than sole proprietorships or partnerships.
- Double Taxation (Key Disadvantage of C-Corporations):
  - Corporation's profits are taxed separately from owners' tax obligations.
  - Shareholders pay taxes twice:
    1. The corporation pays tax on its profits.
    2. When remaining profits are distributed as dividends, shareholders pay personal income tax on that income.

Tax Implications for Corporate Entities

C Corporations:
- Most corporations are C corporations.
- Must pay corporate taxes on profits.
- Shareholders effectively pay taxes twice: once at the corporate level, and again at the personal level on dividends.
S Corporations:
- The firm's profits/losses are not subject to corporate taxes.
- Instead, profits/losses are directly allocated to shareholders based on their ownership share (pass-through entity).
- Shareholders must include these profits as income on their individual tax returns, even if no money is distributed to them (regardless of a dividend or not).

Taxation Examples

Example 1.1: Taxation of C Corporation Earnings
- Problem: Corporation earns $5.00$ per share before taxes. Corporate tax rate $40$ \%; personal dividend tax rate $15$ \%.
- Calculation:
  1. Corporate Taxes: $\$5.00 \times 0.40 = \$2.00$ .
  2. Earnings After Corporate Tax: $\$5.00 - \$2.00 = \$3.00$ .
  3. Personal Dividend Tax: $\$3.00 \times 0.15 = \$0.45$ .
  4. Remaining Earnings to Shareholder: $\$3.00 - \$0.45 = \$2.55$ .
- Evaluation: Shareholder keeps $\$2.55$ from original $\$5.00$ . Total taxes paid: $\$2.00 + \$0.45 = \$2.45$ . Effective tax rate: $\frac{\$2.45}{\$5.00} = 0.49 ext{ or } 49\%$
Example 1.1a: Taxation of C Corporation Earnings (with new values)
- Problem: Corporation earns $\$10$ per share before taxes. Corporate tax rate $35$ \%; personal dividend tax rate $10$ \%.
- Calculation:
  1. Corporate Taxes: $\$10 \times 0.35 = \$3.50$ .
  2. Earnings After Corporate Tax: $\$10 - \$3.50 = \$6.50$ .
  3. Personal Dividend Tax: $\$6.50 \times 0.10 = \$0.65$ .
  4. Remaining Earnings to Shareholder: $\$6.50 - \$0.65 = \$5.85$ .
- Evaluation: Shareholder keeps $\$5.85$ from original $\$10$ . Total taxes paid: $\$3.50 + \$0.65 = \$4.15$ . Effective tax rate: $\frac{\$4.15}{\$10} = 0.415 ext{ or } 41.5\%$
Example 1.2: Taxation of S Corporation Earnings (Rework of Ex. 1.1)
- Problem: Rework Example 1.1 assuming S-Corp treatment. Earnings $5.00$ per share; personal non-dividend income tax rate $30$ \%.
- Calculation:
  1. Corporate Taxes: $\$0$ (S-Corp pays no corporate taxes).
  2. Personal Income Tax (on full earnings): $\$5.00 \times 0.30 = \$1.50$ .
  3. Remaining Earnings to Shareholder: $\$5.00 - \$1.50 = \$3.50$ .
- Evaluation: The $\$1.50$ in taxes is substantially lower than $\$2.45$ in the C-Corp example. Shareholder is left with $\$3.50$ instead of $\$2.55$ . However, in an S-Corp, taxes are paid immediately on income, regardless of whether it's distributed as a dividend or reinvested.
Example 1.2a: Taxation of S Corporation Earnings (Rework of Ex. 1.1a)
- Problem: Rework Example 1.1a assuming S-Corp treatment. Earnings $\$10$ per share; personal non-dividend income tax rate $28$ \%.
- Calculation:
  1. Corporate Taxes: $\$0$ .
  2. Personal Income Tax: $\$10 \times 0.28 = \$2.80$ .
  3. Remaining Earnings to Shareholder: $\$10 - \$2.80 = \$7.20$ .
- Evaluation: The $\$2.80$ in taxes is substantially lower than $\$4.15$ in the C-Corp example 1.1a. Shareholder is left with $\$7.20$ instead of $\$5.85$ . Similar to Example 1.2, S-Corp income is taxed immediately at the personal level irrespective of distribution.

The Financial Manager

Three Main Tasks:

Make Investment Decisions (Capital Budgeting):
- Weigh the costs and benefits of each investment or project.
- Decide which investments are good uses of stockholders' money.
- Most important aspect: Investment decisions directly impact value creation and wealth maximization for shareholders.
Make Financing Decisions (Capital Structure):
- Decide whether to raise money from new and existing owners by selling more shares of stock (equity).
- Alternatively, decide whether to borrow money instead (bonds and other debt).
Manage Short-Term Cash Needs (Working Capital Management):
- Ensure the firm has sufficient cash on hand to meet its daily obligations.

The Goal of the Financial Manager:
- Overriding Goal (Key Concept): Maximize the wealth of the owners, the stockholders.

The Financial Manager’s Place in the Corporation

Control Structure:
- Stockholders own the corporation but depend on financial managers for active management.
- Direct control rests with the Board of Directors and the management team, headed by the CEO.
Organizational Hierarchy (Typical):
- Board of Directors
- Chief Executive Officer (CEO)
- Chief Financial Officer (CFO)
  - Treasurer (responsible for Capital Budgeting, Risk Management, Credit Management)
  - Controller (responsible for Accounting, Tax Department)
- Chief Operating Officer (COO)
Ethics and Incentives in Corporations (Agency Problems):
- Occur when managers prioritize their self-interest over shareholders' interests.
- CEO's Performance:
  - Poor stock performance may lead to the board replacing the CEO.
  - Corporate governance issues: A