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Western University
Management and Organizational Studies
Management and Organizational Studies 1023A/B
Maria Ferraro

Chapter 1: The Purpose and Use of Financial Statements Accounting Matters  Accounting is the information system that identifies and records the economic events of an organization, and then communicates them to a wide variety of interest users.  Marketing offers a good example of how having an understanding of the basics of accounting; marketing managers must also be able to decide on pricing strategies based on costs. Users and Uses of Accounting  Internal users of accounting information plan, organize, and run companies. They work for the company.  Users need detailed accounting information on a timely basis; be available when it is needed.  Investors and creditors are the main external users of accounting information; others include: customers, taxing authorizes, regulatory agencies, economic planners. Ethical Behaviour  Ethics in accounting is of the utmost importance to accountants and decision- makers who rely on the financial information they produce. Forms of Business Organization  Proprietorship: o Simple to set up; gives you control over the business; only relatively small amount of money is needed to start; owner receives all profit, loses, and is personally liable for all debt.  Partnership: o Formed because one person does not have enough resources to initiate or expand a business; partners bring unique skills to the partnership; unlimited liability for all debts of the partnership; some can be formed with limited liability with partners.  Corporations: o You receive shares to indicate your ownership claim; investing relatively small amounts of money. o Factors that need to be considered when deciding which organizational form to choose; legal liability and income taxes. o Proprietors and partners pay personal income tax on their respective share of the profits, while corporations pay income taxes as separate legal entities on any corporate profits. o Private corporations do not issue publicly traded shares; these companies almost never distribute their financial statements publicly. Business Activities  Financing Activities: o Two ways to make money; (1) borrow money, (2) issuing/selling shares. o Amounts owed to creditors are called liabilities. o Funds taken from a line of credit owed to a bank is called bank indebtedness. o Short-term or long-term notes payable can apply to debt (i.e. mortgage, lease, car etc.) o Common shares in the term used to describe the amount paid by investors for shares of ownership in a company. o If you loan money to a company, you are their creditors; the law requires that creditor claims be paid before shareholder claims. o Companies pay shareholders a return on their investment on a regular basis, as long as there is enough cash to cover required payments to creditors. o Borrowing cash from lenders by issuing debt, or conversely, using cash to repay debt; cash can be raised from issuing shares, or paid to shareholders by distributing dividends.  Investing Activities o Assets are resources that a company owns; assets are capable of short-term of long-term lives; investments are short-term and long-term. o Purchasing and disposing of long-lived assets such as property, plant, and equipment and short-term or long-term investments.  Operating Activities o Most of a company’s long-lived assets are purchased through investment activities, assets with shorter lives result from operating activities. o Amounts earned from sales of goods and services are called revenues; revenues increase economic resources; an increase in an asset or a decrease in a liability. o Sources of revenue that are common to many businesses are sales revenue, service revenue, and interest revenue. o The right to receive money in the future is called accounts receivable; result in future benefit. o Other examples include: income tax receivable. o Items that are held for future sale to customers result in an asset called inventory; the cost of inventory sold is an expense called cost of goods sold. o Expenses are the cost of assets that are consumed or services that are used in the process of generating revenues; operating expenses, depreciation, and interest expense. o Obligations that businesses must pay are accounts payable; interest payable, dividends payable, salaries payable, and goods and services taxes payable. o When revenues are more than expenses, net earnings result; when expenses exceed revenues, a net loss results. o From day-to-day operations and include revenues and expenses related accounts such as receivables, inventory, and payables. Communicating With Users  Statement of Earnings reports revenues and expenses to show how successfully a company performed during a period of time; issue of share and distribution of dividends do not affect net earnings.  Statement of Retained Earnings indicates the portion of company’s earnings that was distributed to you and the other shareholders of a company in the form of dividends, and how much was retained in the business to allow for future growth; cumulative earnings that have been retained in the corporation; pay high dividends (Manitoba Telecom and Rothmans); pay low dividends (Indigo Books, RIM).  Balance Sheet presents a picture of what a company owns, what is owes, and it’s net worth at a specific point in time; assets and claims to those assets at a specific point in time; claims of creditors before owners; shareholder’s equity is in two parts (1) share capital, (2) retained earnings; creditors analyze the balance sheet for the likelihood to repay debt.  Managers use the balance sheet to determine whether inventory is adequate to support the future sales and whether cash on hand is sufficient for immediate cash needs. Managers also look at the relationship between total liabilities and shareholder’s equity to determine whether they have the best proportion of debt and equity financing.  Cash Flow Statement shows where a company obtained cash during a period of time and how that cash was used; provide financial information about the cash receipts and cash payments of a business for a specific period; answers these questions: (1) where did cash come from during this period? (2) how was cash used during the period (3) what was the change in the cash balance during the period?.  The Statement of Shareholders Equity explains the changes in all of the equity components.  The Statement of Comprehensive Income must be prepared by a business when other types of income are gained or lost.  External reporting condenses and simplifies information so that it is easier for the reader to understand. Relationship Between Statements  (1) The Statement of Retained Earnings depends on the Statement of Earnings.  (2) The Balance Sheet and Statement of Retained Earnings are interrelated because the ending amount on the Statement of Retained Earnings is reported as the retained earnings amount in the Shareholder’s Equity section of the balance sheet.  (3) The Cash Flow and the Balance Sheet are also interrelated. The Cash Flow statement shows how the cash account changed during the period by stating the amount of cash at the beginning of the period, the sources and uses of cash during the period, and the amount of cash at the end of the period. The ending amount of cash shown must agree with the amount of cash on the assets section of the balance sheet. Elements of An Annual Report  Publicly traded companies must give their shareholders an annual report each year.  Included are nonfinancial (missions, goals, prospects etc.) and financial information (management discussion and analysis, an auditor’s report, comparative statements, notes, and summaries of key financial ratios. Chapter 2: Financial Statements – Framework, Presentation, and Usage Conceptual Framework of Accounting  The conceptual framework of accounting is “a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, the function, and limits of financial accounting statements. o Guides decisions about what to present in financial statements, alternative ways of reporting economic events, and appropriate ways of communicating this information.  1. It ensures that existing standards and practices are clear and consistent.  2. It makes it possible to respond quickly to new issues.  3. It increases the relevance, faithful representation, comparability, and understandability of financial reporting results.  More than 100 countries throughout the world have already adopted IFRS. (Canada, India, Japan, Korea moved in 2011, US 2014-2016)  The conceptual framework of accounting has four main sections: o 1. THE OBJECTIVE OF FINANCIAL REPORTING  The main objective of financial reporting is to provide information that is useful to individuals who are making investment and credit decisions.  Amounts, timing, and uncertainty of future cash flows, economic resources (assets), and claims to those resources (liabilities an equity).  Should include management’s explanations about the company’s financial activities. o 2. THE QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION  Information should have these qualitative characteristic:  1. Relevance:  It will make a difference in users’ decisions.  Help users make predictions about potential effects of past, present, or future transactions; predictive value.  Help users confirm or correct their previous expectations; feedback value.  Must be timely; available to decision makers before it loses it’s ability to influence their decisions.  2. Faithful Representation:  Financial reporting must present the economic substance of a transaction, not just its legal form.  Must be verifiable, neutral, and complete. o Verifiable means that two or more people reviewing the same information and using the same method, would reach the same results. o Neutrality means the absence of bias, accounting information cannot be selected, prepared, or presented to favour one set of interested users over another. o Completeness means that all the information needed to present economic reality is included.  3. Comparability  When companies with similar circumstances was the same accounting standards.  Enables users to identify similarities and differences between companies.  Enables users to compare company’s financial results over time.  Consistency refers to the use of the same accounting treatment for similar events from year to year.  4. Understandability  Necessary to agree on a base level that will help both the preparer of financial information and its user; that base level is: the average user is assumed to have a reasonable understanding of accounting concepts and policies, as well as a general business and economic conditions; willing to pay for it.  Is greater when the information is classified, characterized, and presented clearly and concisely.  Relevance should be applied first as it will help identify specific information that would affect the decisions of investors, creditors, and other users of accounting information. o 3. ELEMENTS OF FINANCIAL STATEMENTS  These are assets, liabilities, equity, revenues and expenses, and gains and losses. o 4. RECOGNITION AND MEASUREMENT CRITERIA  1. Assumptions o Create a foundation for the accounting process. o Monetary Unit: requires that only things can be expressed in money be included in the accounting records. o Economic Entity: economic activity can be identified with a particular accounting unit, which is separate and distinct from the activities of the shareholders and of all economic entities. o Time Period: the life of a business can be divided into artificial time periods; less than one year are interim reports; the shorter the period, harder to faithfully represent results. o Going Concern: businesses will remain in operation for the foreseeable future; assets would be stated at liquidation value (fair market value) if going concern is not assumed.  2. Principles o Indicate how economic events should be reported. o Generally Accepted Accounting Principles (GAAP) widely recognized and have authoritative support from corporations and legislation.  Cost Principle: assets should be recorded at their cost at the time of acquisition; counters faithful representation.  Full Disclosure: requires that all circumstances and events, which would make a difference to financial statement users be disclosed.  Revenue Recognition: when the “risks and rewards” have passed on, easy to measure, collectability is reassured.  Matching: expenses are matched with revenue, all costs associated with generating revenue should be recorded. “Cause and Effect” relationship.  3. Constraints o Make it possible to relax the principles under certain circumstances.  Materiality: relates to financial statement item’s impact on a company’s overall financial condition and operations; professional judgment.  Material: likely to influence decision of investor or creditor.  Immaterial: will not influence decision maker.  Cost-Benefit: ensures that the value of the information is greater than the cost of providing it.  All this information is enable users to measure how a company is performing. o Intracompany basis (within the company itself) o Intercompany basis (between companies) o Industry Averages (against that particular industry’s averages)  Ratio analysis is looking at least two data and creating relationships. o Profitability  Improving operations?  Relationship between Sales and COGS  Sales – COGS = Gross Profit o Gross Profit % = Gross Profit/Net Sales *100  Revenue – Expenses = Net Profit o Net Profit % = Net Profit/Net Sales *100  Return on Assets = Net Profit/Total Assets *100  Return on Equity = Net Profit/Total Equity *100  Earnings/Share = Net Profit+Tax/Issued Common Share  Price Earnings Ratio = Market Price/Earnings per share o Liquidity,  Short-term ability to pay needs for cash.  Comparing CA’s and CL’s.  Working Capital = CA – CL  Current Ratio = CA/CL  Quick Ratio = CA – Inv. – Prepaids/CL o Solvency  The ability to repay debt upon maturity, as well as interest.  Solvent, but not profitable (still able to pay operations without profit).  Debt/Total Assets Ratio = TL/TA * 100  Times Interest Earned = Earnings BIT/Interest Expense  Free Cash Flow = Net Cash Operating – Dividends – Net Capital Expenditures o Activity  The ability to generate revenues from the overall operations of the business.  Inventory Turnover = COGS/EI  Average Collection Periods = AR/Daily Net Credit Sales Chapter 3 and 4: Information For Decision-Making And Cost Flows and Terminology  A decision is simply the choosing of one option from a set of options to achieve a goal. o Step 1: Specify the decision problem, including the decision maker’s goals.  Decisions help us accomplish goals.  Personal goals might influence decisions.  Understanding the factors that influence the decision maker’s goals and their relative importance is the first step in making effective decisions. o Step 2: Identify options.  Business decisions frequently have numerous options.  Identifying the set of options is one of the most important tasks of management. o Step 3: Measure benefits (advantages) and costs (disadvantages) to determine the value (benefits reaped less costs incurred) of each option.  Every option presents a unique trade-off between benefits and costs.  The value of an option equals its benefits less its costs.  We measure value relative to the status quo, which is doing nothing at all.  Opportunity Cost  Whenever we make a decision and choose an option, we give something up.  Opportunity cost is the value of what you give up by making your decision.  The opportunity cost of any decision is the value to the decision maker of the next best option.  Businesses typically measure value and opportunity cost in terms of money, or profit.  Effective decision makers ensure that the value of the chosen decision option exceeds its opportunity cost.  Putting resources to the best possible use and maximizing their value.  Value and opportunity cost emphasize that every decision involves trading off what we get with what we give up. o Step 4: Make the decision, choosing the option with the highest value.  The best choice is the option with the highest value to the decision maker.  The four-step decision making framework applies equally well to both individual and organizational decisions, however there are two important differences: o Unlike individuals, whose goals have several factors, organizational needs tend to have focused goals. o Organizations are a collection of individuals, individual goals relate to organizational goals; individual goals differ from organizational goals, often leading to actions that are not in the firm’s best interest.  Organizational goals for a for-profit business, specifies according the ownership, usually to maximize profits.  Organizational goals for a publicly traded company maximize shareholder value (maximize returns to shareholders).  Companies hire managers to act in the best interests of shareholders, these individuals wish to maximize their own compensation and happiness.  Owner’s align individual and organizational goals: o Policies and procedures, to define acceptable behavior. o Monitoring, to enforce policies and procedures. o Incentive schemes and performance evaluation, to motivate employees to consider organizational goals.  Planning decisions relate to choices about acquiring and using resources to deliver products and services to customers: which products or services to sell, their prices, and the resources needed, such as materials, labour and equipment.  Keep a watchful eye on how well our plans meet our goals, which is the purpose of control decisions (examining past performance, with the purpose of improving subsequent plans.  The planning and control cycle involves: PIER (Plan, Implement, Evaluate, Revise) o Plan:  Products and services  Customers and prices  Resources o Implement  Use resources to make products and deliver services  Set performance targets  Motivate employees o Evaluate  Actual results  Achievement or performance targets  Reasons for deviations o Revise  Best mix of products and services  Resources necessary  Performance targets  Implement has elements of both planning and control.  The primary role of accounting is to help measure the costs and benefits of decision options (decision makers outside the firm rely on financial accounting, decision makers inside the firm rely on managerial accounting).  Financial accounting information is useful for assessing an organization’s overall current state and future prospects.  Managerial accounting information aims to satisfy the information needs of decision makers inside the firm; determines what products or services to offer, what to purchase, whom to hire, and how to pay them; useful for both planning and control decisions.  Managerial accounting information supports decisions related to the acquisition and use of organizational resources as well as decisions related to motivating, monitoring, and evaluating performance.  Ethics relates to every aspect of the decision framework.  Unethical acts sometimes put a strain on managers as it provides monetary benefits in excess of costs, on occasion.  Ethics shapes decision-making goals and influences the set of options to consider.  Laws, rules, and regulations, organizations, and government specify behaviours that cross ethical boundaries and the resulting penalties. o Sarbanes-Oxley Act of 2002 (SOX) mandates that senior executives of publicly traded companies take individual responsibility for the accuracy and completeness of financial reports.  Individual company policies provide additional guidance regarding standards. o Employee handbooks.  The code of ethics created by the Management Accounts of Canada stipulates that accountants should not engage in any business that is incompatible with the professional ethics of a management accountant. Competence, confidentiality, integrity, and objectivity are expected.  An organization chart: o A Board of Directors: responsible for overseeing the firm’s operations.  Chief Executive Officer (CEO)  Delegates most decisions, highest-ranking executive.  Chief Financial Officer (CFO): responsible for all accounting and financial functions, reports to CEO. o Controller: manages day-to-day accounting and oversees accounting policies. o Treasurer: manages the firm’s cash flow and serves as a contact point for banks, bondholders, and creditors; ensures firm raise the required capital at the lowest cost and uses the capital wisely to maximize shareholder returns. o Chief Internal Auditor (CIA): manages internal audit function.  Functional Manager: oversee operations in key business areas.  Division Managers: oversee day-to-day operations of product lines and managers. o Functional Managers o Division Controllers  The costs associated with getting products and services ready for sale are product costs.  Period costs do not directly relate to readying products or services for sale, these include rent, advertising, customer service, and sales force compensation and relate more to the passage of time.  Period costs are all costs that are not product costs. o Costs Incurred:  Salaries, Facilities Rent, Equipment Depreciation, Utilities, Maintenance  (Product Costs, above Gross Margin)  Accounting, Office Rent, Advertising, Sales Staff  (Period Costs, below Gross Margin)  Service Firms: o Offer not tangible or storable objects. o It can be vital to modify accounting reports and use nonfinancial data to estimate the controllable costs and benefits of a decision option. o Period costs combine controllable and noncontrollable costs, as well as fixed costs and variable costs. o Dividing total product or period costs by the number of customers would yield a poor estimate of the cost per member.  Merchandising Firms: o Buy goods from suppliers and resell the same products to customers. o Inventories are necessary. o Distinguish between cost of goods purchased and cost of good sold. o Firms expense costs of items when they sell the items, not when they purchase them.  COGS = BI + Purchases – EI o Prepare the goods for sale (product costs) and costs associated with sales and administration (period costs). o Costs Incurred:  Goods Purchased  Inventory Account; Product Costs; Above GP  Sales and Administration  Period Costs; Below GP  Manufacturing Firms:  Total Costs  Product Costs (costs of manufacturing the products)  Variable Manufacturing  Direct material (purchases for manufacturing)  Direct labour (payment for manufacturing)  Manufacturing Overhead (the total of these indirect costs)  Variable overhead (energy cost to operate machinery)  Fixed overhead (salaries of shift supervisor)  Period Costs  Selling and Administration (costs with managing organization itself)  Variable S&A (cost of transport and commission)  Fixed S&A (rent and salaries)  Direct Materials + Direct Labour  Prime Costs (primary inputs of manufacturing process)  Variable Overhead + Fixed Overhead  Capacity Costs (indirect costs provide firm with the ability to make its products)  Capacity Costs + Direct Labour  Conversion Costs (expenditures to convert raw materials to finished goods)  When firms purchase raw materials, this is added to the cost of materials inventory account.  Firms incur labour and overhead costs during a given accounting period.  Firms assign the cost of materials, labour, and overhead from the respective inventory and control accounts to a work-in-process (WIP) account.  The sum of materials, labour, and overhead costs added to the WIP account during the period are the total manufacturing costs charged to production.  When firms sell finished goods, they physically transfer goods to buyers.  Firms remove the costs from the FG inventory to the COGS account. Purchase raw materials Materials Inv. Labour Pay Wages WIP Inv Control Overhead Overhead Control COGS Finished Goods Inv. Chapter 12: Performance Evaluations in Decentralized Organizations  Benefits of Decentralization o Permits timely decisions with the best available information  Employees at lower levels have access to more detailed and timely information. o Tailors managerial skills and specializations to job requirements.  Expertise and experience required to manage business and increase the firm’s size and complexity.  Decision making to individuals with appropriate functional experience enhances decision quality. o Empowers employees and increases job satisfaction.  Powerful motivational tool gives employees a sense of ownership and results in increased job satisfaction. o Trains future managers  Prepares employees at the lower level for high-level positions.  Costs of Decentralization o Leads to decisions that emphasize local goals over global goals.  Lower-level managers may not understand the big picture.  Make decisions without considering the impact on other organizational units. o Requires costly coordination of decisions.  Proper internal information systems, formal coordination mechanisms; ensure that all managers work toward the same organizational goals. o Triggers improper decisions because of the divergence between individual and organizational goals.  Worsens this problem by giving control over organizational resources to lower-level managers who are far removed from top management. o May lead to an increase in total costs.  Effort and tasks are often duplicated.  Cost Centres o Control over costs, NOT revenues and investments.  Minimize the cost of producing a specified level of output or the cost of delivering a specified level of service.  Improve efficiency of operations by finding ways to cut cost of minimize waste.  Ex. Plant maintenance, data processing, human resources, production, and general administration.  Revenue Centres o Control over revenue.  Expenses but not those required manufacturing the product or delivering the service.  Expenses associated with selling, such as sales, commissions, advertising, and travel.  Ex. Sales divisions, fundraising departments.  Profit Centres o Minimize costs and maximize revenues.  Ex. Proctor and Gamble, Sears.  Investment Centres o Influence costs, revenues, and investments. o Maximize the returns from invested capital, or to put the capital invested by owners and shareholders of their organizations to the most profitable use.  Ex. Large independent divisions: Sony, Seimens, Microsoft  Controllable performance measure holds decision makers accountable only for the costs and benefits that they can control. o Ex. Production manager accountable for production delays; marketing managers have the authority to changes prices.  Informative Principle holds a measure is informative if it provides information about a manager’s effort.  Evaluating a firm relative to another firm in industry is a relative performance evaluation.  An ideal performance measure: o Aligns employee and organizational goals o Yields maximum information about the decisions or actions of the individual or organizational unit o Is easy to measure o Is easy to understand and communicate  Rewarding employees help align organizational and employee goals; ensures they pay attention to customers.  Cost centre managers serve two roles: achieving cost targets in the short term, and continuous efficiency improvements in the long run.  In the short term, organizations typically use budget variances to measure cost centre performance.  Operating budgets specify resources needed to achieve a targeted level of output for a planned period. o Makes assumptions about material usage and prices to determine expected quantities of raw materials and their costs.  Long-term measures: o Benchmarking: comparing the effectiveness and efficiency of various activities and business processes against the best practices in the industry.  Holds a manager accountable for achieving greater reductions in a cycle time. o Kaizen (improvement) encourages continuous improvement and rewards employees who constantly seek and suggest improvements to activities and business processes.  Holds managers accountable for achieving permanent cost reductions  Engineered cost centres have a clear relation between inputs and outputs.  Discretionary cost centres, measuring output can be difficult. o Ex. Output is intangible for legal staff making corporate decisions. o Evaluation is primarily subjective. o Required to operate within a fixed budget set at top management’s discretion; meet qualitative targets.  Evaluating a profit centre focuses on managers maximizing profit: increases revenues and decreases costs.  Firms use profit before taxes to evaluate a profit centre. o PBT = Revenue – Variable Costs – Traceable Fixed Costs = Contribution Margin – Traceable Fixed Costs  Firms use the master budget as the benchmark because a profit centre manager has decision right over outputs and inputs.  Use profit variances analysis to disentangle the effects of these various factors on profit shortfall and to isolate controllable deviations.  Firms measure profit centre managers’ ability to meet long-term goals in addition to delivering the operating profit budget for the current period. o Revenue-oriented measures include customer satisfaction and market share. o Cost-oriented measures might focus on employee turnover or the number of process improvements.  Investment centres are considerable decentralized organizations. o Ex. Cadillac, Buick, Chevrolet  Sets business priorities, provides strategic direction, allocates investment funds and monitors performance of its divisions.  Evaluation of an investment centre focuses on how well it uses the funds made available. o Return on Investment (ROI), Residual Income (RI), Economic Value Added (EVA).  Manager is meeting or exceeding performance expectations, allocate available funds to divisions in the most profitable manner.  ROI = Profit/Investment  Investment centres profit is a result from operations; all revenues and expenses.  Assets like marketable securities and land are not included in calculation, usually measured by corporate.  ROI is an effective summary measure of business profitability; evaluate investments by comparing their ROIs with similar investments in the past and the experiences of other firms.  ROI fosters underinvestment; focusing on current income and investment, ignore future-period considerations, less suitable for the long-term.  Net Book Value (NBV) is the original acquisition less accumulated depreciation.  Gross Book Value (GBV) is the original acquisition cost; fails to measure the change in value with passage of time.  Replacement or Current Value (RV/CV) is more likely to represent the true value of the asset. Identifying the replacement costs, or current value, can be difficult and tedious.  ROI can be decomposed in smaller pieces (DuPont model): o = Profit/Investment = Profit/Sales x Sales/Investment o = Profit Margin x Asset Turnover o Profit Margin = Profit/Sales = Sales – Operating Expenses/Sales  = 1 – Operating Expenses/Sales  Residual Income (RI) is the amount that an investment generates above and beyond the required rate of return on operating assets. o RI = Profit – Required Return x Investment  Represents the additional profit or value generated by an investment after meeting the required rate of return, does NOT lead to underinvestment  Two key limitations: the magnitude of RI depends on the size of the investment; rankings depend crucially on the chosen rate of return.  Economic Value Added (EVA) reflects the belief that managers are responsible for covering both the operating and the capital costs of a business, including taxes. o EVA = NOPAT – WACC x (Invested Capital – Current Liabilities)  NOPAT is the net operating profit after taxes.  WACC is the weighted average cost of capital.  NOPAT requires a number if adjustments to the income reported in the financial statements.  EVA calculations also specify how to measure the weighted average cost of capital and the investment base. o Expensing research and development costs reduce NOPAT, which will affect EVA. o Managers are reluctant to undertake valuable R&D activities. o Capitalizing research and development costs and expensing them gradually over time, better reflects the fact that R&D provides benefits for years.  These focus on the short-term; current profit and investment.  Longer-term focus, such as market share, customer satisfaction, and growth in new product sales. Chapter 1: Introduction to Finance  Finance: o The study of how and under what terms saving (money) are allocated between lenders and borrowers. o How resources are allocated and under what terms, and through what channels.  Funds transferred under a financial contract are called a financial security.  Real assets represent the tangible things that compose personal and business assets.  Finance is essentially the management of an entity’s balance sheet.  Buying another firm, or asset acquisition (capital expenditure)  Financing those expenditures, or corporate financing.  Financial assets are simply what others have lent to another. o Canadian households owned net financial assets issued by the government, corporations, and non-residents with a market value of $2.344 trillion.  Four major areas of finance: o Personal finance o Government finance o Corporate finance o International finance  A shock in the government or international sectors can quickly work through the system to affect personal and corporate finance.  Younger, less wealthy people have a net negative financial asset position.  Older, higher-income people have a net positive financial asset position.  The household sector is the primary provider of funds to business and government.  Financial flow is “intermediated”: o Financial Intermediaries: transform the nature of the securities they issue and invest in. o Market Intermediaries: simply make the markets work better.  Intermediation is the transfer of funds from lenders to borrowers. o Borrowers obtain funds directly OR indirectly from individuals who have first loaned in their savings to a financial institution.  Direct intermediation: o First channel, the lender provides money directly to the ultimate borrower.  A non-market transaction, exchange is negotiated between borrower and lender. o Second channel, lender provides money directly to the ultimate borrower with help, as no one individual can lend the full amount.  A market intermediary is an entity that facilitates the working of markets and helps provide direct intermediation.  Market intermediaries are called brokers.  Ex. real estate, stock market, insurance brokers.  They assist with the transaction and bring borrowers and lenders together, do not change the nature of the transaction.  Financial institutions lend the money to borrowers but raises the money itself by borrowing directly from the individuals.  The ultimate lenders have only an indirect claim on the ultimate borrowers; their direct claim in on the financial institution (a chartered bank) o Largest bank in Canada is RBC (revenue-wise) o They are deposit takers and lenders.  Insurance companies are called contractual savers. o You buy life insurance and then pay premiums; you die, the policy runs off.  Largest insurance company in Canada is Manulife Financial.  “Pure” companies insure homes and cars.  Pension plans are also contractual savers. o Largest pension fund manager in Canada is the Caisse de depot et placement du Quebec!  Chartered banks take in deposits and make loans, insurance companies take in premiums and pay off when an incident occurs, such as a death or a fire, while pension funds take in contributions and provide pension payments after plan members retire.  Mutual funds perform: o A pool of small sums of money so that they can make investments that would not be possible for smaller investors. o An offer of professional expertise in management of those funds.  Major issuer of financial securities: the borrowers! st  March 31 is the fiscal year end for Canada. o The biggest spenders after the federal government in Ontario and Quebec; then Crown corporations like Hydro Quebec and Ontario Power Generation Inc.  Governments raise money: o Taxation o Monopolizing and charging higher fees on things that we want. o The only debt people can invest in and know for sure they will get the promised payments.  The business sector has three times larger net debt position than the government.  GM Canada is the biggest Canadian company in terms of sales.  Financial assets are formal legal documents that set out the rights and obligations of all parties involved. o Two major financial security categories:  Debt instruments:  Legal obligations to repay borrowed funds  Maturity date  Interim interest payments  Ex. Bank loans, commercial papers, bankers’ acceptances, treasury bills, mortgage loans  Equity Instruments:  An ownership stake in a company  Common form is a common share  Preferred shares entitle owners to fixed dividend payments before common shareholders. o Non-marketable financial assets:  Savings accounts or demand deposits  Available on demand  Guaranteed liquidity  Ex. Canada Savings Bond (CSB)  These are non-marketable; they are not tradable.  Can be cashed in at any bank at any time, plus any interest. o Marketable financial assets:  Traded amount market participants.  Debt or equity securities and by their maturity date.  Money market securities: short-term debt instruments, T-bills, commercial paper, and Bas.  Capital market securities: long-term debt in securities, bonds, and debentures.  Equity securities: ownership in a company and generally have no maturity date.  Governments raise new financing via the debt markets. o Issue T-bills as a source of short-term financing, issue bonds and CSB’s for long-term financing.  Businesses raise: o Short-term financing through loans, or issuing commercial paper, BAs. o Raise long-term financing by issuing bonds or in the form of equity.  Primary markets: o Issue of new securities by the borrower in return for cash from investors.  Ex. government sells new issues of T-bills or bonds, company sells new common shares to the public.  Secondary markets: o Key to the wealth transfer process. o Provide trading environments that permit investors to buy and sell existing securities.  Exchanges or auction markets  Involve a place in a specific location  Investors are represented at these markets by brokers  Dealer or over-the-counter (OTC) markets  Do not involve a physical place with a location  A network of dealers who trade directly with one another o Major exchanges are now computerized since 1997.  In 1999, there were five exchanges: o TSX, ME, VSE, WSE, ASE  In 2000, that five then turned into two: o TSX and the TSX Venture Exchange  Had 3,758 issuers in 2005.  Seventh largest exchange in the world.  Only other exchange in Canada is the Winnipeg Commodity Exchange (handles future trading in commodities)  Traditionally, exchanges were for not-for-profit organizations. o TSX is for-profit institutions owned by its shareholders. o Marketing intermediaries:  “Participating organizations” or “Approved Participants” (brokers) do not have to own seats to trade. o The average daily trading volume in January 2006 was 321,287 transactions for a value of $5.6 billion, so, on average, shares worth more than $5 billion changed hands every day.  Trades in unlisted securities in Ontario, the Ontario Securities Commission (OSC) requires them to be reported on the Canadian Unlisted Board Inc. automated system. o The first Canadian quotation and reporting system is the Canadian Trading and Quotation System Inc. (CNQ). o Provides an alternative market for very small emerging companies.  A third market: o Trading securities that are listed on organized exchanges in the OTC market, important for “block trades”. o Extremely large transactions involving at least 10,000 shares or $100,000.  A fourth market: o Trades that are made directly between investors. o Operates through use of privately owned automated systems (Instinet, Institutional Network), owned by Reuters. Chapter 2: Venture Capital and Initial Public Offering  To raise money, one can: o Can borrow; o Sell equity; o Both  Managements goals is to raise the amount of money necessary to finance business at the lowest cost.  Governments generally do little to provide the capital and support for businesses in the start-up state.  New businesses are seldom started in large corporations.  Entrepreneurs regularly leave large corporations to start businesses, usually with ideas developed by previous firm  Bootstrapping is the process by which businesses raise “seed money”. o The initial seed comes from entrepreneur or other founders o Venture capitalists do not invest at this stage. o Seed money is used to develop a prototype of the product and a business plan. o Usually last no more than one or two years. o Critical time that determines if business is a viable option.  Venture capitalists: o Help new businesses get started and provide much of their early-stage financing. o Individual VC’s (angels), wealthy individuals who invest own money into emerging businesses. o VC’s firms pool money from various sources and invest it in new businesses. o 42% of VC’s funding comes from private and public pension funds, 21% financial and insurance firms. o Industry emerged in 1960’s, first VC limited partnership. o Today, biggest concentration in California and Massachusetts; as well as Research Triangle in NC, Austin, TX, NYC etc. o Many focus on capital firms focus on high-technology investments.  Reasons why traditional sources of funding do not work: o A high degree of risk involved  Most businesses fail; banks, pension funds, insurance companies are risk averse. o Types of productive assets  New firms who have primary assets that are intangible are often difficult to secure financially. o Informational asymmetry problems  Arises when one party has knowledge of transaction and the other does not.  Most investors do not have the expertise to distinguish between competent and incompetent entrepreneurs.  Funding Cycle o 1. Bootstrapping, entrepreneur responsible. o 2. Seed-stage, VC’s provide funds to finish development o 3. Early-stage financing, venture capitalists provide funding to get business up-and-running. o 4. Latter-stage financing, one to five additional stages of financing. o 5. Exit strategy, VC’s sell to a strategic buyer, financial buyer, or sell on the public market.  How Venture Capitalists Reduce Risk o Staged Funding  Opportunity to reassess the management team; can bail out or cut their losses, help management make some midcourse corrections.  Typically go through 3 to 7 stages (mezzanine financing) o Preferred stock is convertible into common stock; ensures VC’s have most senior claim if the firm fails or converts shares into gains. o Personal Investment  Confirms you are confident in the business, highly motivated to succeed. o Syndication  Originating venture capitalists sell percentage of deal to other venture capitalists.  Reduces risk: o 1. Increases diversification o 2. Willingness of other VC’s to share in investment provides independent corroboration that the investment is a reasonable decision. o In-depth knowledge of industry and technology  The Exit Strategy o VC’s are not long-term investors; usually 3 to 7 years. o Exit by selling equity portion o There are usually rules (provisions) regarding exit strategy:  1. Timing  2. Method of exit  3. What price is acceptable  Can be controversial. o a) Strategic Buyer  Looks to create value through synergies between the acquisition and the firm’s existing productive assets. o b) Financial Buyer  Often a private equity firm – intends to hold for a period of time, usually 3 to 5 years, and then sells for a higher price. o c) Initial Public Offering  After an IPO, able to sell shares he or she holds over time.  Majority of VC’s exit through strategic or financial buyers.  Venture Capitalists: o Provide advice to entrepreneurs. o Provide counsel when a business is started and during the early period of the businesses operations. o Require an agreement that:  Gives them unrestricted access to information about the firms operations and financial performance.  Right to attend all board meetings.  Insist on a mechanism giving them the authority to assume control of the firm if the firm’s performance is poor.  Cost of Venture Capital Funding o Cost is very high, but there are high rates of returns of VC’s are not unreasonable. o VC’s bear a lot of risk; for every 10 businesses, only 1 or 2 will prove success; winners cover the losses. o VC’s may generate annual returns of 15 to 25% on the money that it invests.  IPO o A company’s first sale of common stock in the public market; first- time stock is given a special name.  SPO (Seasoned Public Offering) o Sale of securities (stocks or bonds) by a firm that already has similar publicly traded securities outstanding. o Public Offering means that the securities being sold are registered with the Securities and Exchange Commission, and legally sold to the public at large.  Advantages of Going Public o Amount of equity capital that can be raised in public equity markets exceeds capital funded through private sources. o Additional equity capital can usually be raised through follow-on seasoned public offerings at a low cost. o Public markets are highly liquid; investors more likely to pay higher prices for more liquid shares of public firms. o Enable entrepreneurs to grow by giving up ownership. o Active secondary market to buy and sell shares. o Easier for a firm to attract top management talent; aligns management behavior with maximizing stockholder value.  Disadvantages of Going Public o High cost of IPO o Stock is not seasoned (an established record in a public secondary market); the likely liquidity of a stock that is sold in an IPO is less well known and its value is more uncertain. o Cost of complying to SEC regarding disclosure requirements; transparency can be costly. o Failing to meet quarterly earnings projections often see their firm’s stock price drop.  Investment Banking Services o Three basic services:  Origination – gives firm financial advice and getting the issue ready to sell.  Determining whether it is ready for IPO.  Management must obtain a number of approvals from the board of directors.  Must be registered with the SEC; the preliminary prospectus: detailed information, various analysis, and expectations; no sales can be made from this document.  SEC approval is not an endorsement of the wisdom or desirability of making a particular investment.  Underwriting – risk-bearing part of investment banking (price risk)  Underwriter’s Spread o Purchase Price – Offer Price o Covers the IB’s expenses, compensation, and risk.  1. Firm Commitment Basis – investment banker guarantees the issuer a fixed amount of money from the stock sale. o More than 95% of contracts  2. Best Effort Basis – investment banker does not guarantee to see stock at a certain price. o Does not bear price risk, and compensation is based on number of shares sold.  Reducing underwriting risk by creating a underwriting syndicate – reducing risk by portioning out ownership within investment (i.e. may enlist another investment banking firm – a selling group)  Price per share is determined with the following: o Able to sell shares quickly to market. o Create a stable secondary market.  A due diligence meeting is formed to list, gather, and authenticate matters such as articles of incorporation, by-laws, patents, and ask questions.  Distribution – involves reselling securities.  After due diligence period, the underwriter and issuer determine the final price in a pricing call. o Takes place after market has closed for the day.  Management ultimately makes the pricing decision.  Files amendment with SEX, register on SEC, and then put up for sale.  Most securities are presold to investors prior to delivery  Closing – issues certificates of ownership to the underwriter and underwriter delivers payments for the securities, net the underwriter fee, to the issuer. o Usually takes place on the third day.  Proceeds from Stocks o TOTAL PROCEEDS = $40,000,000 = ($20/share x 2 million shares)  Shared by:  1. The firm (37.2 million – $18.60/share x 2 million shares)  2. The underwriter (2.8 million - $1.40 per share x 2 million shares) Chapter 3: Dividends and Dividend Policy  Dividend policy to firm’s overall policy regarding distribution of value to stockholders.  Use dividends to distribute value; dividend is something of value that is distributed to a firm’s stockholders on a pro-rata basis – in proportion to the percentage of the firm’s shares that they own. o This can be anything from cash, assets, or something else available only to stockholders. o Value of the firm is the value per share multiplied by the number of shares; subtract the stockbroker’s commission and fees.  Most common form is a regular cash dividend; cash paid on a regular basis. o Management can position the dividend too low; firms may be able to pay an extra dividend during a time of higher expected earnings.  A special dividend is a one time payment to stockholders to distribute unusually large amounts of cash from excess
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