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CPA #1

by: quincw
GPA 4.0
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About this Document

These notes cover the information that was needed to complete CPA #1, including summaries of the videos and readings.
Principles of Finance
Dr. Rhoades
Class Notes




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This 4 page Class Notes was uploaded by quincw on Thursday September 1, 2016. The Class Notes belongs to FIN 330 at Western Kentucky University taught by Dr. Rhoades in Fall 2016. Since its upload, it has received 3 views. For similar materials see Principles of Finance in Finance at Western Kentucky University.


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Date Created: 09/01/16
 Finance­ science and art of managing money  Financial services­ design and delievery of financial products to public  Managerial finance­ duties of financial manager in business  Financial manager­ manages financial affairs of business  Sole propertiorship­ business owned by one peron  Unlimited liability­ sole properitor can lose everything  Partnership­ business owned by 2 or more people  Articles of partnership­ written agreement to establish business partnership  Corporation­ created by law  Stockholders­ owners of corporation  Limited liability­ stockholders not responsible for entire debt of company  Common stock­ basic form of corporate ownership  Dividends­ distributions of cash to stockholders  Board of directors­ group elected by stockholders to lead the brigade  CEO­ corporate official responsible for day­to­day and is elected by BOD  LP/S corp/LLC/LLP  Earnings per share­ amount earned during period on each share of common stock = total earnings / # of  common stock shares outstanding  Risk­ chance that outcome may differ from that which is expected  Risk averse­ compensation to bear risk  Stakeholders­ groups that have an economic link to firm  Business ethics­ standards of conduct in commerce  Treasurer­ chief financial manager manages firms cash, oversee pension plans, manages key risk  Controller­ chief accountant  Foreign exchange manager­ manages and monitors the firm’s exposure to loss from currency fluctuations  Marginal cost­benefit analysis­ benefit must be > cost  Accrual basis ­  recognizes revenue when a sale is made and expenses when incurred  Cash basis­ revenue and expenses based on inflow and outflow of cash  Corporate governance­ rules by which companies operate  Individual investors­ people who own small stock  Institutional investor­ investment professionals that manage accounts of others  SOX­ corporate financial disclosure information  Principal­agent relationship­ agent acts on behalf of principal   Agency problem­ manages place personal goals ahead of stockholder goals  Agency costs­ costs arising from agency problems loss of shareholder wealth  Incentive plans­ tie management compensation to share price  Stock options­ benefits manages from increases in stock over time  Performance plans­ tie management to EPS or growth in EPS­ cash bonus  Performance shares­ shares of stock given to managers for meeting goals  Cash bonuses­ cash paid to management for reaching goals Finance 1. Managerial Finance­ key role in business­ how to raise funds, cash management, budget formulation and  budget controls, strategic planning 2. Personal financial services­ assists individuals with financial planning (investment planning, tax planning,  retirement planning, estate planning, insurance and risk management) Sole proprietorships, partnerships and S corporations are “pass through entities” Profits are passed through to shareholders and taxed on personal tax returns Entities pay no corporate income tax­ taxed at individual level C Corporation are taxed as separate entities­ double taxation  Account for 80% of revenues Corporate governance: shareholders (elect directors), directors (set policy and do oversight) and officers (day­to­day operations) Shareholders get a return on investment through dividends and price appreciation of shares Share price is determined by cash flow and risk  cash flow DOES NOT equal profit Financial managers use cash basis accounting (based on cash flow) rather than accrual (based on when it’s done) Agency problem­ interest of managers diverges from interest of shareholders What is Finance? Finance­ art and science of managing money Personal: how much we spend, save, and invest Business: raise money, invest money, reinvest or dividend Career Opportunities 1. Financial services: design and delivery of advice and products to individuals, business,  and government 2. Managerial finance: duties of financial manager: develop a budget, extend credit,  evaluate proposed expenditures; raising money­ more regulated, globalized, competitive,  and changed by technology Legal Forms of Business Organization Sole proprietorship, partnership, and corporation: determines risk, fundraising, and taxation Sole proprietorship: one person for own profit; raises capital from personal resources or borrowing; small  usually; independent business decisions­ most common, least profitable Pros: personal income tax level, independence, owners receive all profit Cons: unlimited liability­ creditors can take personal assets if debts are not paid; not continuous Partnership: 2 or more owners established by an articles of partnership­ least common Pros: easier to raise funds, more skill, and personal income tax Cons: unlimited liability, partnership ends when one dies General/regular partnership: all partners have unlimited liability; liable for all debts Corporation: created by law and acts as a “person” that can sue and be sued, make contracts, and acquire  nd property­ 2  most common, most profitable Owned by stockholders who get their equity from common stock or preferred stock (have limited  liability) and acquire gains through dividends or increases in share price residual claimants though,  meaning everyone else gets paid first Stockholders vote for Board of Directors (approve and guide plans­ composed of inside directors:  corporate executives and independent/outside­ community people) who decide managers and CEO who  manages day­to­day operations Pros: limited liability (can’t lose more than invested), can get really big via stock selling, stock is  easily transferred, long life Cons: taxed at corporate level and dividends are taxed too­ double taxation; more expensive to  organize; subject to greater regulation; not “secret” Limited Liability Organizations: LP, S corp, LLC, LLP  pass­through entities Goal of the Firm Maximize shareholder wealth: managers should want to max the wealth of the owners/stockholders Increase the firm share price­ only take action that will increase the stock price Must evaluate the potential return (cash flow) on the risk, and do the action if it will increase the price Profits are measured in earnings per share: amount earned on each share of common stock = total earnings available / number of common stock shares outstanding Want higher earnings per share for profit maximization Does profit maximization lead to the highest possible share price? 1. Timing may change this­ lower profit in short run might be better at the time a. Receipt of funds sooner rather than later is preferred because it can be reinvested more  quickly 2. Cash flow: Profit is an estimate of how a firm is doing whereas cash flow is the actual cash  flowing in and out of the company a. Profits can basically be skewed to show what the company wants b. Higher earnings must be accompanied by higher future cash flows to increase stock  price­ expenses can be reduced to improve profit but that doesn’t mean stock price will  follow suit  3. Risk: A low but reliable profit is better than a fluctuating one a. Return/cash flow and risk are key determinants of the share price b. Higher risk = lower stock price because stock holders do not like risk c. Higher cash flow = higher stock price d. Stockholders are risk averse­ want higher returns on riskier investments and lower returns on safer investments (vertical vs. butterfly) What about Stakeholders? Stakeholder­ employee, customers, suppliers, etc. that have an economic link to the firm Goal not to maximize stakeholder well­being but to preserve it Part of social responsibility­ cooperation amongst stakeholders increases the wealth of the firm The Role of Business Ethics Standards of conduct applying to commerce Firms have employee ethic policy that employee’s must pledge to follow Ethical behavior is viewed as necessary for profit maximization because it reduces lawsuits, and builds  both shareholders and stakeholders confidence Managerial Finance Function Small company: managed by accounting department Large company: separate department linked to CEO through a CFO Treasurer/chief financial manager: manages cash­ invests the surplus, secures the shortfall,  oversees pensions, and manages risk w foreign currency, interest rates, and commodities Foreign exchange manager­ monitors exposure to currency fluctuations Controller/chief accountant: handles accounting (internal; treasurer more external) Marginal cost­benefit analysis­ decisions should only be made when the benefits are greater than the costs New computer: $8,000 New computer benefits: $10,000 Sell old: $2,000 Old computer benefits: $3,000 Benefits of new – benefits of old = $7,000 [marginal benefit] Cost of new – sale from old = $6,000 [marginal cost] Marginal benefit > marginal cost  buy a new computer Accounting Emphasis on Cash Flow Accountants use an accrual basis (recognize revenue at time of sale, regardless of cash) under GAAP  Financial manager uses cash basis (actual movement of cash) to make decisions Nassau sells a boat that it purchased for $80 to a customer for $100. Customer has not paid yet. Accounting (accrual basis): net profit = $100 – 80 = $20 Financial (cash basis): net cash flow = ($80) Decision Making Accountants collect and present data whereas financial managers actually make decisions with the info  based on the risk and returns Primary Activities of Financial Manager: make investment (determines assets the firms hold­ current  assets and fixed assets) and financing decisions (how a firm raises money to pay for assets­ current  liabilities and long­term funds) Governance and Agency Corporate governance­ rules by which companies are operated controlled and regulated Influenced by internal factors (shareholders, BOD) and external (clients, regulations etc.) Individual investors: own small quantities of shares and do not have means to influence corporate  governance, but do elect the BOD  Institutional investors: investment professionals that manage a large amount of securities for others Banks, insurance companies, mutual funds, and pension funds­ can really influence things Government regulation: shapes the corporate governance of all firms 1. false disclosures 2. undisclosed conflicts of interest SOX:  Established an oversight board to monitor accounting industry Tightened audit regulations and controls Toughened penalties against fraudulent executives Strengthened accounting disclosure requirements Instant disclosure of stock sales Established guidelines for conflicts of interest, ethical problems, and corporate BOD structure Increased securities regulation authority Principal agent relationship: agents are the managers, principals are the shareholders Principals want to max shareholder wealth, but they also have their own interests Agency problems: managers deviate from the main goal by putting their interests before the shareholder’s Agency costs: costs borne by shareholders due to presence or avoidance of agency problem (loss of  shareholder wealth) To avoid this: Structure management compensation with firm performance Incentive plan: tie management compensation to share price Grants stock options­ stock price rises over time, can sell for a profit Performance plan: compensation tied w EPS Performance shares­ shares of stock based on performance goals Cash bonuses­ cash payments tied to achievement of performance goals Threat of takeover also keeps things in check 


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