Finance Fundamentals: Impact on Individuals and Organizations
1.1 – What is Finance?
Finance affects the lives of all people and organizations.
- At the macro level, it is the study of financial markets and the financial system, nationally and internationally.
- At the micro level, studies are the financial planning of your organization, such as making decisions based on its balance sheet, evaluating and recommending the acquisition of assets, and profit maximization.
Finance, as the art and science of money management, involves virtually all individuals and organizations raising or receiving, spending, or investing money. The area of finance is concerned with the processes, institutions, markets, and instruments associated with the transfer of money between individuals, government agencies, and companies.
1.2 – What are Financial Services?
Describe the field of financial administration.
It is the area concerned with the development and delivery of advisory services and financial products to individuals, businesses, and government agencies.
1.3 – Common Legal Forms of Business Organization
What mode is dominant in terms of revenue and net income?
The most common legal forms are:
- Sole proprietorship
- Partnership
- Corporation
Individual firms are the most numerous. However, joint-stock companies are dominant in terms of revenue and net income.
1.4 – Roles within a Corporation
Describe the roles and relationships between the main parts of a corporation: shareholders, board of directors, and president. How are owners paid in such a society?
A corporation is an artificial entity created by law. Also known as a legal entity, it has the powers of an individual in the sense that it can issue common or preferred shares. Common shares are the purest and most fundamental property of a corporation. Shareholders receive dividends as a return on their investment.
The Board of Directors has the most authority over the conduct of the company’s affairs and its general policy formulation. The board includes advisors for senior executives of the company and outside professionals, often successful entrepreneurs and executives of other major organizations.
The President (Chief Executive Officer) manages operations on a day-to-day basis and implements policies determined by the board. They are obliged to present periodic reports to the board.
1.5 – Other Legal Forms with Limited Liability
List and briefly describe other legal forms of organization beyond the corporation that provide limited liability for owners.
- Limited Liability Company (LLC): One or more partners have limited liability, provided that at least one member (general partner) has unlimited liability. The limited partners cannot have a say in company management; they are passive investors.
- S-Corporation: For tax purposes, it is an entity organized under section S of the tax code, which allows some corporations with 75 shareholders or fewer to be taxed as a limited liability company.
- Limited Liability Partnership (LLP): Gives its owners limited liability and tax treatment of a partnership.
1.6 – Importance of Financial Management
Why is the study of financial management important regardless of the specific area of activity of an executive in a company?
Administrators need to justify the need for hiring manpower, negotiate operating budgets, deal with financial performance assessments, and sell proposals based on their financial merits. By becoming more skilled, managers can more easily obtain the resources they need to achieve their goals.
1.7 – Financial Activities of the Treasurer
What are the financial activities of the treasurer or financial manager in a mature company?
All areas must interact, and the finance staff must be able to make useful decisions.
1.8 – Basic Economic Principle in Financial Management
What is the basic economic principle used in financial management?
The fundamental economic principle used by financial managers is marginal analysis, whereby a financial decision should be taken only when the additional benefits outweigh the additional costs.
1.9 – Differences Between Accounting and Finance
What are the main differences between accounting and finance regarding cash flow and decision-making?
- Accounting prepares financial statements, recognizes revenue at the time of sale (whether payment has been received or not), and recognizes expenses when they are incurred.
- Finance uses these financial statements to avoid insolvency and help the company achieve its goals.
- Another difference is in decision-making. Accounting aims to collect and present financial data.
- Finance evaluates financial statements, produces additional data, and makes decisions based on the assessment of returns and risks.
- Accountants do not make decisions; financial managers collect formal data.
1.10 – Activities Related to the Balance Sheet
What are the two basic activities related to the financial manager of the company balance sheet?
- Making investment decisions
- Making financing decisions
Investment decisions determine both the composition and the types of assets.
Financing decisions determine both the composition and the types of financial resources used by the company.
1.11 – Profit Maximization vs. Wealth Maximization
What are the three basic reasons why profit maximization is incompatible with wealth maximization?
- Timing: The distribution of when a company receives revenue.
- Cash Flow
- Risk
1.12 – Risk and Return in Financial Decisions
What is risk? Why should both risk and return be considered by the financial manager who is evaluating an alternative decision?
Risk is the possibility that actual results will differ from expected results.
Return and risk are the basic determinants of stock prices, which represent the wealth of shareholders in the company.
1.13 – The Goal of a Company
What is the purpose of the company and therefore all its managers and employees?
The goal is to maximize the wealth of its owners, on whose behalf it is governed.
The financial manager should accept only those alternatives that tend to increase the share price.
1.14 – Economic Value Added (EVA)
What is Economic Value Added (EVA)? How is it used?
EVA is a popular measure used by many companies to determine whether a proposed or existing investment makes a positive contribution to shareholder wealth. This value is calculated by subtracting the net operating profits of an investment from the cost of funds used to finance it.
Investments with positive EVA increase shareholder wealth, while those with negative EVA reduce it.
1.15 – Business Ethics and Stock Price
Describe the role of policies and guidelines of business ethics and discuss the relationship believed to exist between ethical behavior and stock price.
It is believed that an effective ethics program raises the value of the company because such a program can produce a series of benefits, such as:
- Reducing the occurrence of disputes
- Reducing litigation costs
- Maintaining a positive company image
- Increasing shareholder confidence
- Gaining the loyalty, commitment, and respect of various interest groups linked to the company
These actions, by preserving and increasing cash flow and reducing perceived risk, may favorably affect the stock price. Ethical behavior is therefore seen as necessary to reach the goal of maximizing owner wealth.
1.16 – Market Forces and the Agency Problem
How do market forces, including shareholder activism and the threat of acquisition of control, serve to prevent or minimize the agency problem?
In theory, most financial managers would agree with the goal of maximizing owner wealth. In practice, however, administrators are also worried about their own wealth, job security, and fringe benefits. Such concerns may make them reluctant to take on higher risks if they think it might threaten their jobs or reduce their personal wealth. The result is a return less than the maximum possible and a probable loss of wealth for the owners.
1.17 – Agency Costs
Define agency costs and explain why companies assume them. How can executive compensation schemes help reduce agency problems? What is the current vision of the execution of many compensation plans?
Agency cost is a term used in business, arising from the original form in English, to name a special type of expense that arises from agency conflicts existing in an organization. These conflicts arise when one or more individuals hire another person or organization, called agents (or managers), to perform some service, delegating decision-making authority to them. These decisions, however, may conflict with the interests of shareholders, giving rise to the typical agency conflict, which, in turn, raises the agency cost.
Companies assume agency costs because the objective is to offer an incentive for managers to act in accordance with the interests of the owners. In addition, the resulting compensation packages allow companies to compete for the best managers available in the market, thus increasing their chances of hiring them.
1.18 – Participants in Financial Institution Transactions
Who are the main participants in the transactions of financial institutions? Who are the plaintiffs and net suppliers of liquid funds?
The main participants in financial institution transactions are individuals, companies, and government agencies. Individuals are the net suppliers, and companies are the net demanders of liquid funds.
1.19 – Role of Financial Markets in the Economy
What role do financial markets play in our economy? What are the primary and secondary markets? What is the relationship between financial institutions and financial markets?
Financial markets are forums in which suppliers and demanders of funds can transact directly. While loans and applications by financial institutions are made without the direct knowledge of fund providers (savers), in financial markets, they know the fate of the loan or application.
- The primary market is where new securities are sold, i.e., when you buy shares directly from the company.
- The secondary market can be seen as a trading market for securities previously owned by someone else.
Financial institutions actively participate in financial markets as both suppliers and demanders of funds.
1.20 – The Money Market
What is the money market? How does it work?
The money market is created by a financial relationship between suppliers and demanders of short-term funds. It exists because some individuals, companies, government agencies, and financial institutions have temporarily idle funds that they wish to invest for some return. At the same time, other individuals, businesses, government agencies, and financial institutions are in need of temporary or seasonal financing. The money market meets these suppliers and demanders of short-term funds.
1.21 – The Eurocurrency Market
What is the Eurocurrency market? What is LIBOR, and how is it used in this market?
The Eurocurrency market is an international market for domestic money. It also represents a market of short-term bank deposits denominated in U.S. dollars or another easily convertible currency. LIBOR (London Interbank Offered Rate) is a base rate used to quote all loans in Eurocurrency. LIBOR is usually used as the basis of remuneration for on-lending in dollars to companies and government institutions. For example, much of the Brady Bonds paid with an interest rate based on the LIBOR benchmark.
1.22 – The Stock Market
What is the stock market? What are the main securities traded on it?
The capital market is where transactions between suppliers and demanders of long-term funds take place. It includes issues of securities of companies and government agencies. The backbone of this market is formed by the various stock exchanges that offer a place to do business with bonds and stocks. The main capital market securities are bonds and common and preferred shares.
1.23 – Role of Securities Markets in Capital Markets
What role do securities markets play in the capital markets? How does the over-the-counter (OTC) market work? How does it differ from the stock market?
The stock markets are those in which companies can raise funds by selling new bonds, and bond buyers can resell them easily when needed. The OTC market is one in which intangible assets are traded through the purchase and sale of unregistered securities on the stock exchanges. Traders in the OTC market, or distributors of securities, are linked to buyers and sellers of securities by the NASDAQ system.
The difference is that in the OTC market, the purchase price is the highest offered by a distributor, and the sale price is the lowest they are willing to accept to get rid of the security.
1.24 – International Capital Markets
Briefly describe international capital markets, in particular, the Eurobond market and international stock markets.
International capital markets enable businesses of a certain country to trade their securities outside their home countries. For example, a U.S. company could issue bonds that would be denominated in U.S. dollars and acquired by investors from Belgium, Germany, and Switzerland.
1.25 – Efficient Markets
What is an efficient market? What determines the price of a security in a market like this?
An efficient market allows for the allocation of funds to their most productive uses. Securities actively traded on major exchanges, in which competition between investors who want to maximize their wealth, determine and announce prices that they believe are close to the true values.
1.26 – Tax Treatment of Ordinary Income and Capital Gains
Describe the tax treatment of ordinary income and capital gains. What is the difference between the average tax rate and the marginal tax rate?
The ordinary income of a company is represented by revenues from the sale of goods or services. Currently, it is taxed in accordance with the established rates. The difference between the average tax rate and the marginal tax rate is that the average rate paid on the ordinary income of the company can be determined by dividing the total tax due by its taxable profit, while the marginal tax rate represents the rate at which additional profit is taxed.
1.27 – Dividend Exclusion for Intercompany Investments
Why could the exclusion of dividend payments between companies make investment in the stock of one company more attractive than the use of fixed-income securities of another firm?
Because capital gains are added to ordinary income and taxed at the ordinary income marginal tax rate.
1.28 – Benefit of Expense Deductibility
What is the benefit resulting from the deductibility of certain expenses of a company?
The deductibility of interest and other expenses reduces its effective cost (after tax) for the company. The non-deductibility of dividends paid results in double taxation for the corporation.
1.29 – Tax Loss Carryforward and Carryback
How does the transfer of tax losses to prior years and future years work when a company has an operating loss in a certain year?
Tax relief – Transfer of tax losses to prior years or future years softens favorable taxes. Tax losses can be carried back and applied to pre-tax profits.