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INTRODUCTION TO CORPORATE FINANCE---FINANCIAL STATEMENTS AND TAXES (540-1)

EO 1.
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EO 2.
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3.

EO 3.

FINANCIAL MANAGEMENT IS CONCERNED WITH THREE ACTIVITIES:


CAPITAL BUDGETING plans and manages the firms long-term investments.
Financial managers predict the size, timing, and risk of future cash flows from investments.
CAPITAL STRUCTURING is the mix of debt and equity the firm uses to finance its operations.
Financial managers decide how and where to raise money, and they compare lenders and loan
types to get the most money from the safest and least expensive sources.
WORKING CAPITAL MANAGEMENT plans and manages the firms short-term assets and
short-term liabilities. Financial managers decide
a.
how much cash and inventory to keep on hand,
b.
whether to sell goods and services on credit, and
c.
how to get short-term financing.
THE THREE GENERAL FORMS OF BUSINESS ORGANIZATION:
A SOLE PROPRIETORSHIP is a business owned by one person.
There are more sole proprietorships than all other businesses, combined.
Advantages: The owner makes all the decisions and keeps all the profits.
Disadvantages: The owner has unlimited liability for business debts.
All business income is taxed as personal income.
The amount of equity that can be raised is limited to the owners personal wealth.
The business exists only until the owner dies.
And, the transfer of ownership can be difficult.
A PARTNERSHIP is an unincorporated business owned by two or more people or entities.
A general partnership has all partners share profits and losses, as described in their partnership
agreement.
A limited partnership has
a.
one or more general partners who run the business and bear unlimited liability for business
debts and
b.
one or more limited partners who do not participate in running the business and bear limited
liability for business debts.
The advantages and disadvantages of a partnership are the same as for a sole proprietorship.
A CORPORATION is a business that is a legal entity distinct from the people or entities of
which it is composed.
A corporation can borrow money, own property, sue and be sued, and enter into contracts.
A corporation must have
a.
articles of incorporation, which supply basic information about the proposed corporation
to the state that will incorporate it and
b.
by-laws, which are the corporations own rules for conducting its business.
In a large corporation, the stockholders elect the board of directors (sometimes known as a board
of governors), which then hires executives and managers to run the corporation.
Joint stock companies, public limited companies, and limited liability companies (LLCs) are all
corporations.
Advantages: Ownership is easy to transfer.
The life of the corporation is not limited.
Stockholders liability for business debts is limited to the amount theyve invested in the
corporation.
And, the corporation can raise capital by selling new shares of stock.
Disadvantage: Corporations are subject to double taxation: Profits are taxed as corporate
income when earned and again as personal income after theyre paid out as dividends.
FINANCIAL GOALS could include survival, avoidance of financial stress and bankruptcy,

2004 exams
Copyright 2003

Orders: 1-888-BURNHAM, 9 to 5 Eastern. Please, tell a friend.


540-1-1
by Ray Burnham, Southbridge MA 01550
Purchasers use only.

beating the competition, maximizing sales or market share, minimizing costs, maximizing profits, and/or
maintaining steady earnings growth.
Financial goals fall into two classes: Some increase profits, others decrease risks.
Profit maximization is an imprecise goal because it doesnt include
1.
a time limit--Increase profits over six months? One year? Five years? Twenty years?
2.
a form of measurement--Maximize accounting net income? Earnings per share? Cash flow?
THE GOAL OF FINANCIAL MANAGEMENT: Maximize the current value per share of the existing
stock. A business that doesnt issue stock maximizes the value of its owners equity.
EO 4.
THE AGENCY RELATIONSHIP is the relationship between stockholders and managers.
The agency problem is the possibility of conflicts of interest between stockholders and managers.
Agency cost is the cost of conflicts of interest between stockholders and managers, usually measured in
lost investment opportunities, corporate expenditures that benefit managers but not stockholders (buying an
unneeded corporate jet), and expenses incurred to monitor managers.
Managers act in the best interests of stockholders when
1.
managers goals are closely aligned to stockholders goals--Tie managers compensation to the
businesss financial performance or stock price.
Promote managers who meet stockholders goals.
2.
managers can be easily replaced--Stockholders can replace managers through a proxy fight or
through a takeover.
[A stakeholder is someone other than a stockholder or creditor who has a claim on a businesss cash flows.
Stakeholders include employees, customers, suppliers, and governments.]
EO 5.
HOW PRIMARY MARKETS OPERATE: In a primary market, a corporation sells securities
for the first time.
A public offering sells securities to the general public.
A private placement sells securities to a specific buyer (or to specific buyers).
Corporations must register their public offerings with the Securities and Exchange Commission (SEC).
HOW SECONDARY MARKETS OPERATE: In a secondary market, a securities owner sells his
securities to another buyer.
A dealer market (aka an over-the-counter market) has the securities owner sell his securities directly to the
buyer.
An auction market sells securities through brokers and agents, who match sellers with buyers.
The largest auction market in these US is the New York Stock Exchange (NYSE).
THE BALANCE SHEET lists the firms
assets (owned resources, amounts owned by the firm),
liabilities (owed resources, amounts owed by the firm), and
owners equity(ies) (owners claims, aka net assets and net worth), (residual amount owned by
the firms owners). [I favor owners equities rather than owners equity, since there are levels
of owners equities and since assets and liabilities are plural.]
at a certain point in time, like a freeze-frame snapshot.
Assets are either
1.
current (likely to be converted to cash or consumed within one year) or
2.
fixed (not likely to be converted to cash or consumed within with one year).
Fixed assets are either
EOs 6 + 8.
1.
2.
3.

2004 exams
Copyright 2003

Orders: 1-888-BURNHAM, 9 to 5 Eastern. Please, tell a friend.


540-1-2
by Ray Burnham, Southbridge MA 01550
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1.
2.

tangible (able to be touched, such as buildings, trucks, and computers) or


intangible (not able to be touched, such as copyrights, trademarks, and patents).

Liabilities are either


1.
current (payable within one year) or
2.
long-term (not payable within one year).
The balance sheet identity: Assets = liabilities + owners equities (shareholders equity).
Net working capital equals current assets minus current liabilities.
When examining a balance sheet, a financial manager considers
1.
liquidity--describes the ease with which an asset can be converted to cash.
Highly liquid assets can be sold quickly with little loss of value.
Illiquid assets can not be sold quickly without a significant loss of value.
Highly liquid assets have lower returns than illiquid assets, but they also reduce the firms chance
of financial difficulty when paying debts or raising funds to buy assets.
2.
financial leverage--is a firms use of debt.
Firms use long-term debt with (usually) fixed interest rates to increase the return on (owners)
equity (ROE).
3.
market values--Balance sheets use generally accepted accounting principles (GAAP), which
show assets at their
a.
book or accounting values (what the firm paid for them, minus depreciation) rather than
b.
market values (what theyre worth today).
EOs 7 + 8. THE INCOME STATEMENT is the financial statement that summarizes the businesss
performance over a period of time (like a movie).
The income statement shows the firms operating results (net operating income) as current revenues
(income from operating activities) minus current expenses (operating costs).
The income statement equation: Income = revenues - expenses.
The bottom line on the income statement is net income (earnings from operations minus interest expense and
minus income taxes).
When examining financial statements generally or income statements specifically, a financial manager
considers
1.
GAAP--Income statements that use GAAP recognize revenues when they accrue, not when they
are received. Cash inflows and outflows may be recognized long after theyve occurred.
2.
noncash items--are expenses charged against revenues that do not directly affect the cash flow.
The depreciation of assets produces noncash items. An asset that cost $5,000, depreciated over 5
years, will show an annual $1,000 deduction even though the firm paid the entire $5,000 up front.
The depreciation simply matches the cost of the asset with the revenue it generates.
3.
time and costs--All costs are variable over time, but some costs (such as taxes or executive
salaries) appear fixed in the short-term. Financial managers classify costs as product costs (costs
of goods sold) and period costs (general, selling, and administrative (GSA) expenses).
[The average tax rate equals total taxes paid divided by taxable income.
The marginal tax rate equals the amount of tax payable on the next dollar earned.
A flat-rate tax uses the same rate for all income levels.
In a flat-rate system, the marginal tax rate always equals the average tax rate.]

2004 exams
Copyright 2003

Orders: 1-888-BURNHAM, 9 to 5 Eastern. Please, tell a friend.


540-1-3
by Ray Burnham, Southbridge MA 01550
Purchasers use only.

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