FINC311 exam 1 study guide PDF

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Exam 1 study guide with Professor Lynch...

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o Chapter 1: Introduction to Corporate finance o Examples of questions finance answers:  What long term investment projects should the firm take on?  Capital budgeting  Where will the firm get the long-term financing to pay?  Capital structure  How will the firm manage its everyday financing activities?  Working capital management o Corporate Finance  Short term capital  Determine how much to pay in dividends to shareholders  During 2008 there was no short-term cash available for companies to borrow o Goal of the finance firm to maximize shareholder’s wealth & maximizing the price of existing common stock  Benefits of maximizing shareholder wealth:  Direct benefits to shareholder  Society benefits as business compete to create wealth  The stock prices includes effects of all financial and operational decisions  Companies that are successful have MORE shareholders/ stockholders/investors o The funds and capital available in society will go to the company and if you take them away from companies that are struggling then the stock price will go DOWN  Example: kmart and sears are not doing well^^ target and Walmart are taking over  Profit maximization  Timing of earnings and profits are very important  Risk is very important in finance  Goals are estimations- not exact o Legal forms of business organizations: 3 main +LLC  1. Sole proprietorship (1 owner)  owned by an individual  owner holds titles to assets  termination occurs on owners death or by owners choice -

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Advantages very easy to do(can register online) owner has greatest control over company all profits are claimed as income for owner(not taxed by IRS) individual tax rates are lower than corporate

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Disadvantages unlimited liability(you as owner are liable for ALL obligations)

2. Partnership (two or more owners)  3 types of partnerships: o

1. General partnership

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each general partner is fully responsible for liabilities or joint unlimited liabilities  general partners get to vote o 2. Limited partnership  allows one or more partners limited liability – names may not appear in name of firm  limited partners may not participate in management decisions  MUST have at least ONE GENERAL PARTNER w/ unlimited liability and the rest are limited partners with limited liability  Only general partners can vote NOT LIMITED(they have no say) o 3. Limited liability partnership (LLPs)  allow individual partners for not being liable for wrong doing of the sole partner w/o bringing down the whole company  malpractice insurance will protect general partners so they are limited liability  Examples: medical practices, law firms, accounting firms Advantages Disadvantages Easy to form - Unlimited liability (you as owner are Partners have control liable for ALL obligations) - Difficult to raise large sums of money Do not pay corporate taxes Have more than one person brining in their resources to the company (advantage over sole partnership) 

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3. Corporation (20% of companies are corporations)  shareholders are the legal owners of the company o transfer of ownership is not a big deal  separate legal entity  they are taxed separately o they are taxed on their income o whatever is left after taxes is given to shareholders as dividends  Corporations choose how they want to be taxed: Types of corporation:  (c and s- corporations are identical in the sense of limited liability perspective) o C-Corp  Each year the % of tax the corporation pays is based off of the profit they made that year  Disadvantage: shareholders have to pay double taxes (on profit and dividends)  Why choose C-corp?  because S-corp you cannot have more than 75 shareholders, shareholder has to be US citizen, shareholder has to be individual o S-Corp  Does not pay taxes on its profit  Profits flow right through to the shareholders and they pay taxed ONLY on the profit

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They are taxed in proportion to their ownership Cannot have more than 75 shareholders Has to be US citizens Cannot be a company- only individuals can be shareholders

Advantages -Liability for all owners - easy to raise capital (issues stocks and bonds) - the company stays open until someone decides to shut it down

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Disadvantages - Complicated to form a corporation need lawyers/accountants need to go through extensive register process - highly regulated (federal & state gov.) -double taxation

B-Corporation  Used for non-profits and companies that benefit society  A type of corporation that is required (by state) to create a general benefit for society as well as shareholders  Publically report their social and environmental performance & earnings  Goals of B-Corporation:  1. Making profits for the company  2. Make profit for shareholders  3. Benefits society  Examples of B-corporation: Essential Living Foods, Home Free, Clean Yield Asset Management, Clean tech Law Partners

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4. LLC  Limited liability Company (LLC) o When they file to the state they file as Certificate of Limited Liability Company o Has limited liability protection like a corporation o ALL members vote o They can elect to be taxed any way they want:  Sole, Partnership, Corporation (C or S) o They business profits are NOT taxed by the IRS like c-corporations (owner runs profit as personal income through IRS)  tax schedule is lower than a company  The business can operate as a corporation with the protection of legal entity & limited liability

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Business Share (%) by legal structure     

Types % of firms Corporations 20.3% S-Corps 10.5% Partnerships 8.2% Sole Proprietorships 60.9%

% of Rev. 80.0% 9.7% 6.7% 2.1%

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RIC and REITs 0.1% 1.5% o real example: 2016 presidential election

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Donald Trump heavily focused on small businesses because they hire a lot of employees (create jobs)  They do not have a lot of revenue compared to corporations but they provide A LOT of jobs (“bread and butter”)

Finance in Corporations  Corporation organizational structure  Board of directors: o 1. Chief Executive Officer (CEO)  appointed to execute the polices  directions that the board and organization create  day-to day running the company  authorizes the share of stocks o 2. Vice President of Marketing o 2. Vice President of Finance (CFO)  top financial manager  responsible for all financial record keeping, planning, and handling funds o 2. Vice President of Human Resources o 3. Treasurer  responsible for receipt, custody disbursement, investment of funds, cash management, credit management o 3. Controller  Typically, a CPA  Responsible for preparation of all financial statements & reports, internal audits, data processing, compliance o Governments roll in the economy  All countries have TWO sets of policies available to the gov. to manage the econ  1. Fiscal= describes the use of TAX REVENUE and GOV EXPENDITURES to manage the economy  2. Monetary= describes the actions of the CENTRAL BANK (federal reserve) in controlling the MONEY SUPPLY and INTERESR RATES in the economy o federal reserve manages the money in the country & SETS INTEREST RATES (making sure there isn’t high inflation or recessionary economy) o Objective of Income tax  1. To raise revenues for the government expenditures  2. Using fiscal policies to encourage desirable investments and desirable corporate behaviors while discouraging undesirable ones (achieve socially desirable goals)

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3. Using fiscal policies to encourage economic growth during recessions & using tax penalties to discourage spending to curb inflation (achieve economic stabilization)  examples of socially desirable fiscal policies: o Target Jobs Tax Credit (TJTC) provides tax credits for employers who hire workers from economically disadvantage background o The Work Opportunity Tax Credit (WOTC) provides tax credits to employers who hire workers from targeted groups (ex: Veterans) o Alternative motor vehicle tax credit for purchasing non-gas powered vehicles o Renewable energy/investment tax credit for investment in wind solar fuel cells o Low income housing tax credit developers who build low income housing o Types of tax payers:  Individuals- employees, self-employed persons, members of partnership (report income on personal tax return)  Corporations- report income on corporate tax returns (separate legal entity) 

Distribute dividends taxed to shareholders o Example of corporate vs. individual tax rates:  Suppose a company made $500,000 in taxable income in a given year. Below is an estimate of the company’s tax liability if it is organized as a corporation and paying corporate tax rates or organized as a sole proprietorship or partnership and paying individual tax rates.  Corporate: Taxable income is $500,000. o Tax = $113,900 + [.34(500,000-335,000)] o = $113,900 + $56,100 o = $170,000  Individual: Taxable income is $500,000. o Tax = $118,118.75 + [.396(500,000-406,750)] o = $118,118.75 + 36,927 o = $155,045.75 Taxable income:  Gross income- dollar sales from a product or service less cost of production or acquisition  Taxable income- gross income less tax deductible expenses, plus interest income and dividend income  Tax deductible expenses- operating expenses( marketing, depreciation, administrative, and interest expenses)  DIVIDENDS ARE NOT TAX DEDUCTABLE (THEY ARE POST TAX EXPENSES) Other corporate tax considerations:  Dividend exclusion- a corporation may typically exclude 70% of any dividend received from another corporation 

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Capital gains and losses: [encourage investors to invest for longer than a year} o Short term capital gains are taxed as ordinary income o Long term capital gain is taxed at 20% (10% for those in the 10% & 15% tax bracket) o Capital losses cannot be deducted from ordinary income (they attract different tax rate)  Net operating loss: carry back and carry forward [what Trump did w/ taxes] MORE NOTES ON BACK OF PRINTED NOTES  in any fiscal year, if a business accumulates an operating loss then the tax law gives you the opportunity to carry the loss backwards 2 years or carry it forward 20 years o example: they will let you tax the loss and go back a couple years so you made a profit- then they will take the gain you made in 2015 and the loss in 2016. Whatever taxes you paid the IRS will pay it back to you o 10 principles that form the foundations of financial management:  Principle 1: the risk return tradeoff  The more risk an investment has- the higher the expected return  Investment alternatives have different amounts of risk/return  Principle 2: the time value of money  A dollar received today is worth more than a dollar received in the future because INTEREST  Principle 3: cash-not profits- is king  Cash flow is used to measure wealth (not profit) because cash flow is received as can be reinvested  Principle 4: incremental cash flow  The difference between the projected cash flow (if the project is accepted) vs. what they will be if project is not accepted  Principle 5: the curse of the competitive market  If one industry is making a large profit - competitors are attracted to them and try to compete (give a run for their money) o Examples: patents on drugs/ copyright  Principle 6: efficient capital markets (stock market)  The value of all assets & securities at any instant in time fully reflect all available information  public market so everyone needs to be disclosed with all information- no insider trading  Principle 7: the agency problem  The separation of management and owners/principles of the firm creates an agency problem  make sure everyone is on the same page  Principle 8: taxes bias business decisions  Relocating a business so they can pay lower taxes  Trump looks at taxation so they don’t have to pay taxes  Principle 9: all risk is not equal  Risk can be diversified allows good and bad events to cancel each other which reduces total variability w/o affecting expected return 

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Principle 10: ethical behavior  Each person has their own set of values for personal judgement o Chapter 2: Introduction to interest rates and capital market o The Federal reserve system [est. 1913 by congress]  The Fed is the central bank of the USA, which includes banking for commercial banks and the bank of the US government.  Has a 7 member board of governors (chaired by Janet Yellen)  12 regional banks- Philly, NY, Boston, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kanas City, Dallas, San Francisco  3 responsibilities of the Federal reserve:  1. US Monetary Policy manages the supply of money and interest rate levels  2. Provide payment services serve as a bank for banks, check clearing services, currency  3. Supervise & regulate banks enforce banking laws, soundness, protect consumers o stress test seeing how sound they are or how close to failing  Objectives of the Federal reserve system  Control unemployment rate  Control inflation (maintain price stability  If in a recession, take actions to jump start economy  Open market operations/ quantitative easing when the fed pumps money into the economy (when in danger like 2008)  Bond marker the fed buys or sells bonds to commercial banks o Increase money supplies  o Target rates  Federal discount rates interest rate charged on short term loans  If a bank is at risk for falling below the Fed requirement they borrow money to make up the difference  Federal fund rates short term market rate of interest (indicates future rates)  This rate is charged money is borrowed- tend to be overnight loans o Prime rates  interest rates commercial banks charge their most preferred customers  Also used to set interest rates for credit card, home equity loan rates, auto loan rates, personal loan rate o Debt  funds borrowed from a creditor w/ an obligation to pay interest [no offer of ownership] o Equity funds offered by individuals(shareholders) or companies in return for ownership NO OBLIGATION to pay interest  Equity funds comes with ownership o Debt/Equity Mix US tax system favors debt as means of raising capital  INTEREST EXPENSE IS DEDUCTIBLE  DIVIDENDS PAID ARE NOT DEDUCTIBLE o The mix of corporate securities in the capital market  Corporate stock is NOT the financing method most relied upon 

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 Corporate debt is the dominant financing method Real assets tangible assets such as houses, equipment, and inventories Financial assets nonphysical assets such as: security, bank balance (they represent claims for future payments on other economic units) Financial market a market for the exchange of capital and credit (money and capital markets) Movement of funds through the economy  Direct transfer of funds  Indirect transfer of funds using an investment banker  Goldman Sachs  Morgan Stanley  JP Morgan chase  UBS  Insurance companies, mutual fund companies, private equities Structure of US financial markets  FEAR AND GREED DRIVE THE MARKET  When corporations need to raise external capital- funds can be obtains by:  Public offering where individuals and institutional invests have the opportunity to purchase securities (investment=stock or bond) o Initial public offering (IPO) company that was privately held decides to go public [ex: snapchat] o Seasoned equity offering (SEO) any time you issue stock after IPO  Private placement--. When securities (investment=stocks or bonds) are sold to limited number of investors Primary Market new issues of securities are sold to investors. This is the market you sell in if you want to raise capital  The issue of the new stock increases total stock of financial assets outstanding in the economy  Securities are purchased directly from issuer – this is just trading between investors  The company benefits from this  Institutional investors companies that have large amount of wealth/ capital that can purchase a lot of stock Secondary market  shares of stocks are already in circulation(issued previously) is sold among investors. Investors buy security from another investor NOT from the issuing company  Sales do NOT change the total stock in financial assets that exist in the econ  Investors benefit from this Money market short term debt instruments with maturities of ONE YEAR or LESS  T-bills (treasury bills) a security issued by the department of treasury and serves as a medium for government to raise funds. o Not much return on investment  Matures in a year or less.  Issued at discount and pay the face value at maturity o Sold by the department of treasury @weekly auctions

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Commercial papers  short term IOU (promissory note) issued by large corporations to raise funds (this is UNSECRED[no assets to back it up])  Only large companies typically can do commercial papers  Federal agency securities short term securities issued by:  federal home loan mortgage corp (FHLMC)  Federal national mortgage association(FNMA)  Government national mortgage association (GNMA) o Creating mortgage loans for home owners o Create secondary market for mortgage loans they buy loans from mortgage companies and banks Capital market a market where debt and equity securities are traded- long term financial instruments w/ maturities that extend beyond one year  Terms loans  Financial Leases  Stocks and Bonds Organized security exchange  tangible entities where financial instruments are traded on the premise  National and regional exchanges:  New York stock exchange, American SE, National SE, Philly SE  Benefits of organized exchange:  1. Provides a continuous market  someone will always be willing to buy or sell stocks  2. Established and publicizes fair security prices  the price of stock changes any day due to interaction of supply & demand  3. Helps business raise new capital Over the counter markets  all security market except the organized exchange  National association securities dealer’s automotive quotations (NASDAQ) the first all-electronic stock exchange created in the world Dow Jones industrials publishes the wall street journal,  Consists of major transportation, industrial, and utility companies in USA  We track their performance and the average to get an idea of how the transportation is doing Listing requirements varies from exchange to exchange but general:  Profitability- 10 million a year (NASDAQ only need 500,000)  Size- NYSE or NASDAQ  Market value- should have a certain market value  Public ownership- a certain # of shares should be publically owned 2 types of banking in US (know difference for exam)  1. Commercial banking you take your deposits to a bank and when you demand your deposit the bank is obligated to give you that amount  they turn around and take your deposit money and lend it out to businesses and companies- they charge interest rates on the loans they give out (the difference is the profit the bank makes)  2. Investment banking their primary role is to take private companies public  [ They are listed on the exchange- need the help of investment banks] 

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investment banker a financial involved as an intermediary in the merchandising of securities- facilities flow of saving from economic units that want to invest to those units that want to raise funds  functions of investment banker:  underwriting- raise investment capital from investors on behalf of corporations & governments that are issuing either equity or debt securities  distributing advisingo Glass Steagall Laws (1933-1999) was designed to separate commercial banks and investment banks (NOW REPEALED BECAUSE BANKS DO BOTH NOW)  Did not want commercial banks engaging in investment banking  Help publically traded companies raise capital o Market ...