BU121 Final Notes PDF

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BU121 FINAL NOTES TOPICS TO BE COVERED: Main concepts from text and readings will be tested with multiple choice questions (as indicated with blue text), unless otherwise indicated. Lecture material some lab manual material will be tested in more depth (as indicated in black text) with a combination...

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BU121 FINAL NOTES TOPICS TO BE COVERED: Main concepts from text and readings will be tested with multiple choice questions (as indicated with blue text), unless otherwise indicated. Lecture material & some lab manual material will be tested in more depth (as indicated in black text) with a combination of multiple choice, short-answer questions, and problems. Material that is testable through problems is indicated in red text. CASE FUNDAMENTALS Short case with 3 questions  What Is a Case? and Case Analysis: Tips & Tools FINANCE Text Chapter 5: Finance: Maximizing the Value Role of finance and the financial manager Financial management  the art and science of managing a company’s money so that it can meet its goals - Closely related to accounting - Accountants main function is to collect and present financial data - Financial managers use financial data/statements made by accountants to make financial decisions AND ensure that cash is available when needed o Focus on CASH FLOWS (inflows/outflows of cash for a company) The Financial Manager’s Responsibilities and Activities - Financial planning  preparing the financial plan, which projects revenues, expenditures, and financing needs over a given period - Investment (spending money)  investing the company’s funds in projects and securities that provide high returns in relation to their risks - Financing (raising money)  obtaining funding for the company’s operations and investments and seeking the best balance between debt (borrowed funds) and equity (funds raised through the sale of ownership in the business) - MAIN GOAL  to maximize the value of the company to its owners - To maximize the company’s value, manager has to consider both short and long term consequences of the company’s actions - Strive for balance between the opportunity for profit (RETURN) and the potential for loss (RISK) - Risk-return trade-off  Basic principle that holds the HIGHER the risk, the GREATER the return Financial planning Financial plan  the part of the overall company plan and guides the company toward its business goals an the maximization of its value - To prepare, must consider existing/proposed products, resources available to produce them, and the financing needed to support production and sales - Forecasts and budgets are essential to financial planning

o Should be part of an INTEGRATED planning process that links them to STRATEGIC plans and performance measurement Forecasting the Future - The estimated demand for the company’s products (the sales forecast) and other financial and operating data are key inputs - Short-term forecasts/ operating plans projects revenues, costs of goods, and operating expenses over a 1-year period o Theses estimates form the basis for CASH BUDGETS - Long-term forecast / strategic plans cover a period that is longer than a year, typically 2 to 10 years o With this company can assess financial effects of various business strategies o Example:  Investing in new equipment  Developing new products  Eliminating a line of business  Acquiring other companies  Where the funding for activities is expected to come from o Lenders will ask borrower (companies) for forecasts that will cover the period during which the loan will be outstanding  Forecasts are used to evaluate the risk of the loan and cash flow will be able to cover the debt and structure the loan based on that Budgets - Formal written forecasts of revenues and expenses that set spending limits based on operational forecast - Provide a way to control expenses and compare the actual performance to the forecast - When there are differences to the budget, managers can analyze them to see if they need to correct them Example: - Cash Budgets o Forecast a company’s cash inflows and outflows and help the company plan for cash surpluses and shortages - Capital Budgets o Forecast a company’s outlays for fixed assets (plant and equipment), typically covering a period of several years - Operating Budgets o Combine sales forecasts with estimates of production costs and operating expenses to forecast profits How organizations use funds – short term expenses, and obtain funds - Must keep investing money in its operations in order to grow and be successful Short Term Expenses - Used to support current selling and production activities

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Financial manger’s goal is to manage current assets so company has enough cash to bay its bills and support the A/R and inventory

Cash Management: Assuring Liquidity - The process of making sure that a company has enough cash on hand to pay bills as they are due and to meet unexpected expenses - Keep a minimum cash balance to cover unexpected expenses or changes in projected cash flows - Arranges loans to cover any shortfalls - Because cash help in current accounts earns little or no interest, the manager tries to keep cash balances low and to invest surplus cash - Surpluses are invested temporarily in marketable securities, short-term investments that are easily converted into cash o Looks for low-risk investments that offer high returns Example: o T-bills o Certificates of deposit o Commercial papers  Unsecured short term debt (an IOU issued by a financially strong corporation) - Companies with overseas operations face greater cash management challenges o Must deal with multiple foreign currencies, follow regulations set by each country, and be aware of local customs - Tries to shorten time between the purchase of inventory or services and collection of cash from sales o Collect money owed to the company as fast as possible o Pay money owed to other accounts payable as late as possible (without damaging credit rep) o Turn inventory quickly to minimize funds tied up in it Managing Accounts Receivable - A/R  represents sales for which the company has not yet been paid - Goal is collect money owed to the company as quickly as possible while offering customers credit terms attractive enough to boost sales - A/R management involves setting credit policies, rules on offering credit, and credit terms, repayment conditions and deciding on collection policies ( Procedures for collecting overdue accounts o Involves how long customers have to pay their bills and whether they get discounts for quicker payments - Setting up credit and collection policies needs to be balanced o Although easier credit sales result in increased sales, the risk of uncollectible A/R rises o Must consider impact on sales, timing of cash flow, experience with bad debt, customer profiles and industry standards - Technology plays a big role in helping companies improve credit and collections

Inventory - Production managers want lots of raw material on hand to avoid production delays - Marketing managers want lots of finished goods on hand so that customers orders can be filled quickly - Financial managers want the least inventory possible without harming production efficiency/sales - Must balance these conflicting goals Obtaining Short-Term Financing - Shown as a current liability on balance sheet

Unsecured Short-Term Loans -

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Loans for which the borrow does not have to pledge specific assets as security (Collateral) Made on basis of the company’s creditworthiness and lenders previous experience with the company Trade Credit: Accounts Payable The extension of credit by the seller to the buyer between the time the buyer receives the goods or services and when it pays for them Bank Loans Companies often use these loans to finance seasonal businesses Needs short term bank financing to increase inventories before its strongest selling season and finance A/R during late winter/early spring Example: Line of credit  agreement between bank and business/person that specifies the maximum amount of short-term borrowing the bank will make available to that business or person Revolving credit agreements  line of credit that allows the borrower to have access to funds again once it has been repaid o Example: Credit Card  after you pay off you have access to funds again

Secured Short-Term Loans -

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Require borrower to pledge specific assets as collateral Chartered banks and commercial finance are the main sources of this Borrowers whose credit does not qualify for unsecured loans use this method Typically, collateral for secured short-term loans is A/R or inventory o Bcus A/R is quite liquid o Inventory depends on how easily it can be sold at a fair price Factoring  where a company sells its accounts receivable at a discount to a factor o Companies that all all of their accounts reduce the costs of their credit and collection operations o More expensive than bank loan

short and long term – debt and equity

Raising Long Term Financing - Include debt (borrowing) and equity (ownership) - Advantage of debt financing is the deductibility of the interest expense for income tax purposes, which lowers cost - Disadvantage: Financial Risk - Lenders often use “The 6 C’s of Credit” to determine the risk that the borrower will default on debt o Character  past history of the borrower to repay loans o Capacity  ability to repay loan o Capital  amount of cash the borrower has access to o Collateral  pledge of assets by the borrower to the lender o Conditions  issues that affect the business (e.g. economic conditions, competition etc.) o Confidence  the borrower addresses the concerns that the lender may have and gives reassurance that the loan will be repaid -

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Equity  places few restrictions on the company o Gives common shareholders voting rights that provide them with a voice in management o Most expensive o Dividends are not tax-deductible Managers try to select the mix of long-term debt and equity that results in balance of cost and risk

Long Term Debt Financing - Term loan  business loan with an initial maturity of more than 1 year; can be unsecured or secured o Generally, have 5-12 year maturities o Available from chartered banks, insurance companies, pension funds, commercial finance companies, and manufacturers’ financing subsidiaries o May be paid quarterly, semiannual, or annual schedule o Payments include interest and principal - Bonds  Long term debt obligations issued by corporations and governments o Issued in multiples of $1000 with initial maturities of 10-30 years o Stated interest rate is the COUPON rate - Mortgage Loan  long-term loan made against real estate as collateral o Lender takes a mortgage on the property which lets the lender seize the property, sell it and use the proceeds to pay off the loan If the borrower fails to make payments o Used to finance office buildings, factories and warehouses Equity Financing - By selling new ownership shares (external financing) - By retaining earnings (internal financing)

- Through venture capital (external financing) Selling New Issues of Common Shares - Common shares  represent an ownership interest in a corporation - High growth companies has an IPO to raise funds to finance continuing growth - IPO’s enable existing shareholders, employees, family and friends who bought the shares privately to earn large profits on their investment - No guarantee an IPO will sell - Very expensive - Watched closely by regulators, shareholders, and securities analysts - Must reveal financial info, plans and strategies Dividends and Retained Earnings - Dividends  payments to shareholders from a corporations profits o Does not have to pay but if investors buy shares expecting to get dividends and company does not pay them, then investors may sell their shares o If too many people sell  Value of shares DECREASE o Dividends can be paid in cash or in shares  Share dividends are payments in the form of more shares  After a share dividend has been paid, more shares have a claim on the same company so the value of each share often DECLINES o During quarterly meetings, the company’s board of directors decides how much of the profits to distribute o A stable history of paying dividends indicates good financial health - Retained Earnings  profits that have been reinvested in a company o Do not incur underwriting costs o Strive to balance dividends with retained earnings to maximize value of the company o Well established and stable companies and those that expect modest growth like public utilities, financial services companies pay most of their earnings in dividends o High growth company’s like technology related fields finance most of their growth through retained earnings Preferred Shares - Have a dividend amount that is set at the time the shares are issued - Dividends must be paid before the company can pay any dividends to common shareholders - If the company goes bankrupt, preferred shareholders get their money back before common shareholders - Increase the company’s financial risk because it forces the company to make a fixed payment HOWEVER, the company can miss a payment without serious results of falling to pay a debt - More expensive than debt financing - Not tax deductible Future/trends

The CFO’s Role Continues to Expand - They are no longer numbers people, they have joined top management in developing and implementing the company’s strategic direction - Serve as both business partner to the chief executive and fiduciary (someone that is given trust) to the board - Need to have a broad view of company operations to communicate effectively with business unit managers, investors, board members etc. Weighing the Risks - Job of managing risk which was harder after the economic crisis of 2008 and 20011, continues to be harder for financial executives - No longer does risk management focus narrowly on buying insurance to protect against loss of physical assets - Companies now consider ENTREPRISE RISK MANAGEMENT (ERM) o a company wide strategic approach to identifying, monitoring, and managing all elements of a company’s risk - Risks include o Credit risk  exposure to loss as a result of defaulting on a financial transaction o Market risk  risk resulting from adverse movements in volatility of market prices of securities etc o Operational risk  the risk of unexpected losses arising from deficiency in a company’s management info Text Chapter 6: Financing New Ventures Why it is so difficult to raise money and solutions - Entrepreneurs identify uncertain new venture opportunities based on info that other people either do not have or do not recognize - Investors must make decisions about funding new businesses of very uncertain value with less info than the entrepreneur has - Uncertainty and information asymmetry creates problems in financing new companies Information Asymmetry Problems - Entrepreneurs are reluctant to disclose information to investors requiring investors to make decisions on limited information o Need to keep secret the information about their opportunities and their approaches to exploiting them - The information edge that entrepreneurs have makes it possible for them to take advantage of investors o Entrepreneurs can use their superior info to obtain capital from investors and use it for their own gain - The investor’s limited info about the entrepreneur and the opportunity creates the potential for a problem called Adverse Selection o Occurs when a person is unable to distinguish between 2 options o Example: between 2 people, one who has a desired quality and other one who doesn’t

o To protect investors, they charge a premium to pay for the losses incurred from backing the wrong people Uncertainty Problems - They must make judgments about the value of opportunities and the ability of entrepreneurs on the basis of very little actual evidence o factors that determine which ventures will become valuable investments are  demand for the new product, financial performance of the firm, the ability of the entrepreneur to manage the company o when entrepreneur DOESN’T have a patented technology or long track record of building successful business then investor has to make a determination on the basis of very little hard evidence - entrepreneurs and investors often disagree about the value of new ventures o no one really knows how profitable a new venture will be o investors make their financing decisions on the basis of their own perceptions about the profitability and attractiveness of ventures - investors want to make sure that entrepreneurs will pay up if their ventures prove not to be valuable  lowers the risk for investor o investors ask entrepreneurs to provide collateral  PROBLEM!!: many entrepreneurs need capital because they don’t hae anything of value Solutions to Venture Finance Problems Self-Financing - The amount of capital that you contribute doesn’t matter, its about putting an amount that is a large percentage of your net worth o If you don’t think a venture is a good enough idea to risk losing your own money, then why would an investor risk theirs o Investors are worried that unscrupulous entrepreneurs will take advantage of them (ex. Buying a fancy car) - Although making entrepreneurs self-finance is useful for mitigating venture finance problems, it is not a complete solution esp. for large ventures Contract Provisions - To protect themselves, investors include a variety of provisions in their contracts with entrepreneurs - They include covenants on entrepreneur’s behavior o Are restrictions on someone’s actions Example: o Common covenants include:  precluding the entrepreneur from purchasing or selling assets or shares without investors’ permission  Mandatory redemption rights  require the entrepreneur to return the investors’ capital when requested - Employ convertible securities  that will allow investors to convert preferred stock into common stock at their discretion - Use forfeiture and antidilution

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o Forfeiture  require entrepreneurs to lose a portion of the ownership of their ventures if they fail to meet agreed upon milestones o Antidilution  require entrepreneurs to provide investors with additional shares in the new venture so that the investor’s percentage of ownership is not reduced in later rounds of financing Investors give themselves control rights to the new ventures that they finance o Control rights provide the discretion to determine how to use a venture’s assets Investors make it difficult for entrepreneurs to leave the company without investor’s permission or to retain much ownership of the new venture of they leave o Solved by requiring long vesting periods during which time entrepreneurs cannot cash out of their investments

Specialization - Specialize by industry with some focusing - Specialize by the stage of development of the venture, with some investors concentrating on making small investments very early in the lives of new firms or making larger, later stage investments - Helps investors by providing them with contacts among suppliers, customers, and experts who can help evaluate the ventures that they are thinking of backing and by ensuring that the ventures are on the right track once they have invested - Investors can learn the key success factors that will make them better able to assits and monitor new firms - Helps BOTH problems Geographically Localized Investing - Localized investing makes it easier for investors to be heavily involved in new companies - Local investing makes it easier to pick the right companies to back o Find it easier to develop a network of sources of ino about good startups if they focus on a constrained area Syndication - Attract other investors to join in them in making investments - Allows investors to diversify their risks by putting smaller amounts of money into a variety of companies rather than putting large sums into 1 or 2 firms - Helps investors gather info about entrepreneurs and investors o Creates better investment decisions Types of capital - Debt VS. Equity - New ventures rarely obtain debt financing  tend to obtain equity financing instead o Until ventures have generated positive cash flow, they have no way to make scheduled interest payments  need to raise money in a way that doesn’t require them to make fixed payments on that capital o Debt financing at a fixed rate of interest encourages ...