personal-finance

MBA Course: Financial Management Notes

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Business Organizations

  • Three ways to organize a business: Sole proprietorship, partnership, and corporation.
  • Sole Proprietorship: Easiest to form, but has the downside of the owner being fully responsible for all liabilities, profits, and losses. Accounts for about 20% of the U.S. business economy.
  • Partnerships: Relatively easy to set up with no corporate income taxes—partners pay personal income taxes instead. However, transferring ownership can be difficult.
  • Corporations: Legal entities separate from individuals. Public companies are traded in markets. They are subject to double taxation (the corporation pays taxes, and individuals pay taxes on dividends).
  • Hybrid Forms (LLC): Limited Liability Company is a relatively new form where owners (called members) are protected from personal losses and double taxation is avoided. However, LLCs are not ideal for future business expansion because they cannot issue stocks.

Financial Management Goals & Governance

  • The Goal of Financial Management: To maximize the current share value of existing stocks. If a company has no stocks in the market, the goal is to maximize shareholders’ wealth. In the U.S. and UK, shareholder interests are prioritized over other stakeholders (customers, employees, etc.). Note that shareholders are a specific subset of broader stakeholders.
  • Corporate Governance: Shareholders can be individuals or institutions (though the majority of shareholders are generally company founders) and have the right to vote on corporate issues. The Board of Directors represents shareholder interests, acts as the highest authority of a corporation, and includes both inside and outside directors.
    • Committees include: Executive, Audit, Compensation, and Nominating.
    • The Executive Committee sets the priorities for the entire Board of Directors.
  • The Agency Problem: The conflict of interest between a firm’s owners and its managers (who often care more about job security). Regulations and governance help mitigate this.

Financial Statements & Cash Flow

  • Reporting Rules: GAAP is used in the U.S., while IFRS is used in Europe and many other countries. To find financial info, visit a company’s investor relations page or use the SEC’s EDGAR (Electronic Data Gathering Analysis and Retrieval) system.
    • Form 10-K: The company’s annual report, which includes corporate governance details, executive compensation, and audited financial statements.
    • Form 10-Q: Quarterly reports.
    • Form 8-K: Current reports filed for significant events/changes within 4 days.
  • Balance Sheet: Assets=Liabilities+Stakeholders’ Equity.
    • Assets are listed on the left side; liabilities and equity are on the right.
    • Balance sheets track details of profit/loss and vary by company fiscal year.
    • Liquidity: How easily an asset can be converted into cash (current assets are liquid; fixed assets like real estate are harder to convert). Companies should hold appropriate liquid asset levels.
    • Net Working Capital: Current Assets−Current Liabilities.
    • Note: Long-term debt and common stocks remain unchanged on the balance sheet, and the balance sheet must always balance.
  • Income Statement: Income=Revenue−Expenses.
    • Features EBIT (Earnings Before Income and Taxes), Net Income (the bottom line), and EPS (Earnings Per Share based on outstanding shares).
  • Statement of Cash Flows: Breaks cash flows down into three categories: operating activities, investing activities, and financing activities.

Financial Ratios & Analysis

  • Standardized Statements: Used for financial comparisons beyond raw statements.
  • Liquidity Ratios:
    • Current Ratio: Current LiabilitiesCurrent Assets​
    • Quick Ratio: Current LiabilitiesCash+Marketable Securities+Receivables​ (Most conservative compared to the current ratio)
    • Cash Ratio: Current LiabilitiesCash and Cash Equivalents​
    • Operating Cash Flow Ratio: Current LiabilitiesCash Flow from Operations​
  • Financial & Valuation Ratios:
    • Total Debt Ratio: Total AssetsTotal Assets−Total Stakeholders’ Equity​
    • P/E Ratio: Earnings Per ShareCurrent Share Price​

Time Value of Money & Capital Budgeting

  • Time Value of Money: Covers Future Value and Present Value concepts.
  • Net Present Value (NPV):
    • If NPV>0, accept the project.
    • If NPV≤0, reject the project.
    • The discount rate is also called the rate of return.
  • Internal Rate of Return (IRR): Used to decide whether to accept or reject a project. If the IRR is greater than the required rate of return, accept the project. If comparing multiple options, pick the one with the higher IRR.
  • Capital Budgeting Considerations:
    • Incremental Cash Flows: Identifying which types of cash flows matter. Operating Cash Flow=EBIT+Depreciation−Taxes.
    • Net Capital Spending: During a project’s life, net working capital may change, but at the very end of the project, net working capital will return to zero.
    • Opportunity Cost: The cost of not opting for one opportunity by choosing another.
    • Sunk Costs: Costs that have already occurred and cannot be recovered (should be ignored).

Bonds

  • Basics: A bond is a loan that corporations or governments borrow from investors (individuals or institutions like pension/mutual funds). The issuer is legally obligated to repay it.
    • Face / Par Value: Amount repaid at the end of the loan.
    • Coupon: Interest paid at fixed times. Coupon rate is the annual interest divided by the face value.
    • Level Coupon Bonds: Pay interest every year.
    • Zero Coupon Bonds (Discount Bonds): Pay only the face value at the maturity date with no coupons.
  • Valuation & Yield: The primary principle is that a bond’s value is the present value of all future cash flows (present value of coupons + present value of face value).
    • Yield (YTM – Yield to Maturity): The required market interest rate on the bond, expressed as an APR.
    • Inverse Relationship: There is an inverse relationship between interest rates and bond prices.
      • Premium Bond: Coupon Rate>YTM⟹Price>Par Value
      • Par Bond: Coupon Rate=YTM⟹Price=Par Value
      • Discount Bond: Coupon Rate<YTM⟹Price<Par Value
  • Bond Types:
    • Treasury Securities: Issued by the U.S. Treasury (Bills, Notes, and Bonds), primarily differing by maturity time.
    • Agency Bonds: Issued by government agencies; safe, but less liquid than treasury bills.
    • Government-Sponsored Enterprise Bonds: Issued by entities like Fannie Mae and Freddie Mac.
    • Municipal Securities (Munis): Debt of local governments (some are general obligation bonds). Interest is tax-exempt at federal and state levels, though they carry default risks.
    • Corporate Bonds: Carry more risks than government-issued bonds, so they pay higher returns. They can be secured (backed by assets as collateral) or unsecured (riskier, so they must pay higher returns).
  • Bond Ratings: Measured by major rating companies like S&P, Moody’s, and Fitch Ratings to evaluate default risk.

Stocks

  • Basics: Shareholders are the owners of a company (institutional shareholders hold higher sway than individuals). Stocks are traded in primary and secondary markets, and some companies have multiple classes of stock. Major U.S. stock exchanges are the NYSE and NASDAQ.
  • Types of Stocks:
    • Common Stocks: Have voting rights and may receive dividends.
    • Preferred Stocks: Have no voting rights and may receive fixed dividends.