Comprehensive Introduction to Finance, Business Organization, and the Financial Environment
Introduction to Finance in Business and Life
Finance is an indispensable tool for anyone whose career involves making financial decisions or interacting with the finance functions of a firm.
Important investments of a firm involve capital and, therefore, involve finance. This includes activities such as: - Expanding marketing channels. - Developing new products. - Upgrading a factory.
Businesses spend capital on these projects specifically to foster growth.
Understanding the evaluation methods used by finance professionals is essential for success in any business focus.
Finance education provides benefits in personal life by helping individuals understand and make better personal financial decisions.
The Financial Engine and the Flow of Money
The successful application of financial theories facilitates the flow of money from individuals to businesses.
Individuals participate to improve their financial future, while businesses participate to expand the scale or scope of their operations.
Two primary results of this exchange are: - A more productive economy. - Growth in individual wealth into the future.
These exchanges lead to a growing economy and increased employment opportunities across all income levels.
Finance participants are categorized along two dimensions: - Those with extra money (assets beyond current spending needs for investment). - Those with business creativity and the ability to develop viable business ideas.
Economic Roles in Society: The Four Participant Types
Participant types are defined by their access to capital and their ability to generate ideas.
Type 1 Participants: - Provide labor to enterprises and consume products. - Do not lend significant capital or spend money in a business context. - They play no direct role in financial markets (the mechanisms where capital is exchanged).
Type 4 Participants: - Use financial tools to evaluate and choose business concepts with the most potential. - They are self-funded and do not need financial markets to implement their ideas. - Their financial decisions are narrowly focused on their own purposes.
Type 2 Participants (Investors): - Temporarily lend money to Type 3 participants. - In developed economies, these are usually individual investors. - While individuals may have small amounts of extra money, aggregating these funds provides sizable amounts for investment.
Type 3 Participants (Idea Generators): - Put borrowed money to use to execute business ideas. - Expected to repay the money to Type 2 participants plus interest. - These are commonly corporations or companies with Research and Development (R&D) departments dedicated to innovation.
The Process of Capital Exchange and Market Friction
Investors lend extra capital to companies to fund expansion projects.
Successfully executed projects eventually return money plus a profit to the investors.
Sources of friction reduce the amount of capital returned to investors: - Retained Earnings: Funds the firm keeps for ongoing operations rather than distributing to owners. - Taxes: Government-imposed levies used to fund public services.
Major regulatory changes, such as the Tax Cuts and Jobs Act (TCJA) signed by President Trump in $2017$, significantly impact company and individual financial perspectives.
Decision perspectives include: - Individuals assessing investment opportunities based on needs and risk tolerance. - Financial institutions/markets distributing capital efficiently. - Companies evaluating projects, deciding on funding types, and determining how much capital to return to investors.
The Major Sub-areas of Finance
Investments: - Focuses on methods and techniques for deciding which securities to own (e.g., bonds or stocks). - Determines which firm's securities to buy. - Manages how to pay the investor back in the desired form (timing and certainty of promised cash flows).
Financial Management: - Deals with a firm's decisions in acquiring and using cash from investors or retained earnings. - Involves organizing the firm to attract capital and choosing between raising capital via bonds versus stocks. - Addresses which projects to fund, tax minimization strategies, and how to pay back capital providers.
Financial Institutions and Markets: - Entities that facilitate capital flows between investors and companies. - Financial institutions (e.g., banks, pension administrators) are vital to the dynamics of interest rates.
International Finance: - Necessary due to the transition to a global economy. - Accounts for complexities such as future exchange rate uncertainty, political risk, and varying business laws across different countries.
Application and Theory in Financial Decisions
Future cash flows are neither instantaneous nor guaranteed.
Risk: The uncertainty regarding the timing and size of future cash flows.
Financial decisions involve comparing rewards against the risks generated by those decisions.
Value Assessment: The price of a financial asset (stock or bond) depends on the expected future cash flows. - High expected cash flows lead to higher value today. - Investors seek to buy assets when market prices are lower than actual values. - Firms aim to fund projects where the value generated exceeds the cost.
Asset Classes: Grouped by risk and return characteristics. Common classes include: - Stocks. - Bonds. - Money market instruments. - Real estate. - Derivative securities.
Time Value of Money (TVM): The method for relating future cash flows to today's value, known as present value. TVM analysis must account for both the timing and the risk level of cash flows.
Case Study: Quantitative Easing (QE) and Economic Policy
The financial crisis of $2007$-$2008$ led to the Great Recession, which ended in the U.S. in $2009$.
The U.S. Federal Reserve utilized Quantitative Easing (QE) to foster growth during a slow recovery.
QE Definition: A monetary policy designed to increase money supply by buying market securities and lowering short-term interest rates.
QE 1: Involved the Fed buying $1,250,000,000,000$ dollars in mortgage-backed securities from banks to strengthen their balance sheets. The federal funds rate was cut to zero.
QE 2 ($2010$): The Fed purchased $600,000,000,000$ dollars of long-term U.S. Treasury securities to lower long-term interest rates.
QE 3 ($2012$-$2013$): Included "Operation Twist" where the Fed sold short-term bonds to buy more long-term securities.
The Taper and Post-QE: The Fed reduced purchases through $2014$. The first rate hike in nearly ten years occurred on $12/16/2015$ (to $0.25\%$).
Rate Trends: By December $2018$, the rate reached $2.5\%$. In $2019$, rates were cut in increments to $2.25\%$ (August), $2\%$ (September), and $1.75\%$ (October).
COVID-19 Impact: In March $2020$, the Fed dropped the rate to $1.25\%$ and then to $0.25\%$ on March $16$. As of July $2021$, the rate remained at $0.25\%$.
Finance vs. Accounting
Accounting: Primarily keeps track of what happened to the firm's money in the past. It characterizes historical data.
Finance: Uses historical figures combined with current information to determine what should happen now and in the future.
While finance is present and future-oriented, the results of financial decisions eventually appear in accounting statements.
The Financial Manager and Firm Functions
Chief Financial Officer (CFO): The highest-level financial manager in a firm.
Treasurer (Reports to CFO): Responsible for: - Managing cash and credit. - Issuing and repurchasing financial securities (stocks and bonds). - Deciding on capital spending for projects. - Hedging against foreign exchange and interest rate risks. - Overseeing insurance or pension fund investments (in large corps).
Controller (Reports to CFO): Oversees the accounting function, including: - Tax management. - Cost and financial accounting. - Data processing.
Internal Synergy: Operation managers use finance for cost-benefit analysis of production lines; Marketing managers assess survey cost-effectiveness; HR managers evaluate employee benefit package costs.
Personal Financial Applications
Finance principles apply to: - Borrowing for a car. - Refinancing home mortgages. - Managing credit card or student loan payments. - Saving for retirement.
Retirement Shifts: Most companies have shifted from "defined benefit" plans to "defined contribution" plans (e.g., $401k$ plans, IRAs), placing the responsibility for retirement funding on individuals.
Chloe’s Scenario: Chloe can apply business loan analysis tools to her personal debt. This knowledge helps her choose car loans with the lowest true cost and manage retirement accounts to potentially earn millions for the future.
Forms of Business Organization
Sole Proprietorship: - Unincorporated business owned by one individual. - Represents over $70\%$ of all U.S. businesses. - Advantages: Easy to start, light regulatory burden, complete control, owner receives all profits. - Disadvantages: Unlimited liability (personal assets can be confiscated), difficulty obtaining large capital.
Partnerships: - Multiple individual owners. - Profits split by agreement (usually ownership percentage) and taxed at personal rates. - General partners share unlimited personal liability.
Corporations: - Legally independent entity separate from owners. - Can own property, sign contracts, and pay taxes. - Double Taxation: Income taxed at corporate level, then again at personal level when dividends are paid. - Advantages: Limited liability for shareholders (cannot lose more than investment), high access to capital. - Managers control day-to-day operations, potentially leading to conflicts of interest with owners.
Hybrid Organizations (S-Corps, LLPs, LLCs): - Offer limited personal liability and single taxation (pass-through earnings). - Restricted to smaller firms (e.g., S-Corps limited to $100$ shareholders).
Case Study: AB InBev and SAB Miller Merger
In November $2015$, Anheuser-Busch InBev agreed to buy SAB Miller for $104,000,000,000$ dollars.
InBev paid $45$ British pounds (approx $59$ dollars) cash per share, representing a $50\%$ premium over the market price.
To avoid monopoly status in the U.S., SAB Miller sold its stake to Molson Coors Brewing for $12,000,000,000$ dollars.
The deal closed in October $2016$.
Firm Goals and Agency Theory
Primary Goal: Maximizing shareholder wealth (maximizing current stock price).
Owner’s Perspective: Managers have a moral and legal duty to act in owners' interests.
Stakeholder Perspective: Suggests managers should maximize satisfaction for all stakeholders (employees, customers, community), but this often leads to inefficiencies.
Adam Smith’s Invisible Hand: Efficient individual pursuit of interest promotes total community good in the long run.
Agency Relationship: Occurs when a Principal (stockholder) hires an Agent (manager) to act on their behalf.
Agency Problem: Managers may act in their own interest (e.g., excessive perks like luxury cars) instead of shareholder interest.
Mitigating Agency Conflicts: - Ignoring: If the financial impact is small. - Monitoring: Through accounting audits and oversight by large block holders or bondholders. - Alignment: Offering managers equity stakes via stock options or Employee Stock Option Plans (ESOP).
Corporate Governance and Monitors
Corporate Governance: The process of monitoring managers and aligning their incentives.
Internal Monitors: The Board of Directors (hire/fire CEO, design compensation).
External Monitors: - Auditors (examine accounting systems). - Investment Analysts (evaluate business activity for the community). - Investment Banks (advise on capital market interactions). - Credit Rating Agencies/Analysts (examine financial strength). - Government: Securities and Exchange Commission (SEC) and Internal Revenue Service (IRS).
Sarbanes-Oxley Act of 2002: Passed in response to scandals (Enron, WorldCom) to make auditing more transparent.
Case Study: Steve Jobs and the Lifecycle of a Firm
Start-up: Steve Jobs and Steve Wozniak started Apple in $1976$ in a garage using family money and personal proceeds.
Angel Investment: Mike Markkula invested $92,000$ dollars and guaranteed a bank loan of $250,000$ dollars.
Public Offering: Apple went public in $1980$ for $65,000,000$ dollars; Jobs’ ownership was diluted to less than half.
Conflict: The Board hired John Sculley in $1983$; Jobs was forced out in $1985$.
External Success: Jobs bought Pixar for $5,000,000$ dollars in $1986$, maintaining $53\%$ ownership to keep full control.
Return: Apple bought Jobs' firm NeXT for $400,000,000$ dollars in $1997$ to bring him back as CEO.
Outcome: Jobs realigned as an owner with options on $10,000,000$ shares and $30,000,000$ restricted shares. Disney later bought Pixar for $7,400,000,000$ dollars in stock.
The Impact of the Tax Cuts and Jobs Act (TCJA) of 2017
Individual Income Tax Changes: - Reduced rates for most tax brackets. - State and Local Tax (SALT) deduction capped at $10,000$ dollars. - Mortgage interest deductible only on the first $750,000$ dollars of debt (for mortgages after $12/14/2017$). - Standard deduction raised; itemized deductions restricted. - Home equity loan interest no longer deductible.
Corporate and Business Changes: - Flat $21\%$ corporate tax rate (previously graduated up to $35\%$). - Qualified Business Income (QBI): $20\%$ deduction for pass-through entities (LLCs, partnerships, S-corps). - Asset Expensing: Section $179$ maximum deduction increased to $1,000,000$ dollars. Bonus depreciation increased to $100\%$ (scheduled to phase out starting in $2023$ at $80\%$, descending by $20\%$ annually until $20\%$ in $2026$). - Interest Limits: Businesses generally cannot deduct interest expense in excess of $30\%$ of adjusted taxable income. - Net Operating Losses (NOL): Offset limit reduced from $100\%$ to $80\%$ of taxable income; carryback eliminated. - Entertainment: Deductions for business entertainment completely disallowed; business meals remain $50\%$ deductible. - R&D: Expenses must be capitalized and amortized over $5$ years (U.S.) or $15$ years (International).
Questions & Discussion
What are the main sub-areas of finance and how do they interact? Investments focus on what securities to buy; Financial management focuses on how a firm uses cash; Institutions and Markets facilitate the flow of money; International finance handles complexities of the global market.
What is the mission of the Fed regarding employment and inflation? The Fed aims for maximum employment within an environment of $2\%$ inflation.
What is the median CEO compensation package structure? In $2017$, the median was $15,700,000$ dollars, with a ratio of $235:1$ compared to the median worker salary.
Role of Fiduciary Relationships: Finance professionals manage other people's money, creating a moral obligation to act in the client's best interest, reinforced by ethical training and legal punishments for malfeasance.
How does interest rate change affect company expansion? When rates increase, the cost of capital rises, potentially making proposed expansion projects too costly to pursue.