FIN301:

Lesson 1 Overview

Lesson 1 introduces you to a variety of concepts and terms needed for a basic understanding of finance. You will receive a foundational introduction to the field of finance, including a brief look at how finance has evolved over time. You will also be introduced to several key financial concepts and ideas that are the means through which corporations raise and use money, i.e. captial. Future lessons will continue to delve into these theories and practices in more detail. You will also explore how ethics and a corporation's ethical code of conduct should be used to guide these decisions.

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It is important to note that some of the information you will see in this lesson and in Lesson 02 will not be new, as they were covered in your introductory accounting and economics classes. For this class, you will be asked to apply the concepts you already know in a different way. Keep in mind that an accountant compiles and organizes financial data to maintain an organizations financial statements. An economist seeks to understand how to allocate resources to meet consumer demands. A corporation finance officer uses both sets of data to inform decisions with the goal of maximizing value for the company and its stakeholders. 

In Lesson 01 you will also be divided into teams and given the opportunity to invest in the equity market. Thus, you will also be given a brief introduction to the stock market and initial public offerings in this lesson to be followed by more comprehensive study in future lessons. The group project will span the duration of the course; however, here in Lesson 01 you will spend time forming your team, devising your investment strategies, and making your initial stock selections. (See How the Market Works Instructions for further information.)

Learning Objectives

After successful completion of this lesson, you should be able to

• list the different types of business organizations;
• state the main goal of both corporations and stakeholders;
• distinguish the primary and secondary markets;
• recognize the importance of business ethics; and
• use library resources to research corporations.

Lesson Readings & Activities

By the end of this lesson, make sure you have completed the readings and activities found in the Lesson 1 Course Schedule.

Overview of Corporation Finance

There's a well-known cliche: the only constant in business is change. The field of corporate finance continues to evolve to meet the demands of an ever-changing financial environment. What you need to learn and what you need to be able to do as corporate finance professionals also continues to change as a result of those demands.

Types of Business Organizations

You may recall from your introductory accounting course that the type of business organization in which you are affiliated will have ramifications or advantages and disadvantages. Let’s begin with a refresher.

Businesses have the option to organize in four ways:

1. Sole Proprietor
2. Partnership
3. Corporation
4. LLC/LLP

Now, take a look at each type of organization in order to understand it in terms of corporate finance.

Sole Proprietor

In the United States, the most popular type of business organization is the sole proprietor. This is where an individual decides to open up a business on her own. Some of the advantages of opening up as a sole proprietor would include sole decision maker, ease of starting up the business and infinite possibility of one’s individual income. Disadvantages of creating a sole proprietorship would include unlimited liability, lack of other owners/partners, and difficulty for the sole owner to manage both her business as well as personal affairs.

Partnership

A partnership is where two or more individuals decide to form a joint venture. Partnerships include general partners (responsible for all day-to-day business activities) and can include limited partners. A limited partner is only responsible for what they put into the joint venture, ie. funds, advice, etc. A limited partner is not normally responsible for the daily activities of a partnership. An advantage of a partnership is the pooling of assets as well as having at least two individuals involved in the partnership decision making process. A disadvantage can be if the partners no longer want to work with one another and wish to dissolve the partnership. When this occurs, each partner is financially liable, both with the firm’s monies and their personal finances. Also upon dissolve, the firm must shut down. Neither partner can continue with the firm unless the business is reorganized. The partnership agreement should include, amongst other items, procedures for how a possible dissolution of the partnership can take place.

Corporation

A corporation is considered a separate legal entity. In the United States, most business is done through corporations. The main advantage for forming a corporation is separate liability. The main disadvantage of forming a corporation is double taxation. The earnings are taxed at both the owner’s level and then again at the corporate level. There are two types of corporations: “C” corp and a “S” corp. The most prevalent type of corporation, in the United States, is the “C” corp. This type of corporation enjoys the benefits of special tax deductions and is a separate entity concerning tax liability. The “S” corp, on the other hand, passes its losses and gains of income through their personal returns but this allows the owner to avoid double taxation. The “S” corp also allows for some special tax considerations to take place; however, we will not be doing a full analysis of the different types or business organizations in this course.

If you would like more information concerning this topic, check out this Khan Academy video or visit the IRS Web site.

LLC/LLP

A rather popular type of business organization (and fairly new) is the LLC/LLP. LLC stands for "limited liability company" and the LLP stands for "limited liability partnership." They are both hybrids of both the corporation and partnership types of business organizations.

With that said, the LLC and LLP both offer the advantage of limited liability in which the owners are not personally financially liable for the firm's shortcomings. But the firm must be dissolved in the event of death or bankruptcy. Also, if you want to go public with your newly-acquired firm, the LLC/LLP would not be the correct option.

Regardless of which type of business organization the owners choose, financial management is critical to the overall success of the firm.

Agency Relationship and Potential Problems

An agency relationship develops when a third party is hired to represent another party in a certain business transaction. In order to create a successful agency relationship, the two parties must have trust and confidence in one another. For example, an agency relationship exists when a real estate broker is hired by a homeowner to market his real property. Another example of agency would be when a corporation hires a lawyer to represent it in either a legal or business transaction.

Main Goal of Corporation and Stakeholders

For-profit corporations are in business to maximize value for all of their stakeholders. A stakeholder can be defined as anyone who has a vested interest in the success of a corporation including but not necessarily limited to shareholders (holding shares of stock in the corporation), employees, vendors/suppliers, distributors, franchisees, community members, etc. Value will differ depending on the stakeholder. The local community might define value as to how the corporation gives back to the community. An employee might find value when she receives her paycheck or when she receives a raise. A shareholder would like to see an increased stock price (maximization of profits) and that will only happen through an increase in earnings and a management of cost. Furthermore, what might be good for one corporation might not be good for another.

Introduction to Financial Markets

There are two types of markets in the United States equity market: primary and secondary markets. The primary market is where securities are created and the secondary market is where these securities are sold.

Primary

In the primary market, business organizations go from being privately held firms to publicly held firms by conducting an initial public offering (IPO).The firm conducting the IPO receives funds from selling shares of stock (a.k.a., equity) in their company to various purchasers. The firm then can then take those funds and use them for a wide variety of purposes, e.g., put it back into the business, buy down debt, etc.

Secondary

In the secondary market, shares of stock are sold by sellers and purchased by investors but the company itself does not receive any funds in a secondary market transaction.

The following video further explains what it means to buy a company stock. Click the white arrow to launch the video.

How Financial Markets Benefit Society

Financial markets benefit society by allowing corporations to issue shares of stock during an IPO to raise additional capital to both grow their business and benefit their stakeholders. The purchaser of the share of stock has the potential to see their investment grow and/or decline depending on a number of forces both external and internal to the firm, some of which we will cover in our course. If the management of a firm is ultimately successful, than society may benefit in the following ways:

• An increase in wealth to corporation shareholders.
• The corporation, with additional capital at its disposal, may choose to give back to the communities within which it does business.  

Business Ethics

In running a business organization today, firms need to put in place a written code of conduct that all employees should be expected to follow. In the code of conduct, the firm should be explicit in what behavior is considered to be both ethical and acceptable. In addition, examples of what is considered to be unethical and not in accordance with the firm's values should be stated as well. Clearly, a firm's management needs to highlight what is expected behavior of their employees and to take disciplinary action when an employee's behavior is not in accordance with the firm's written code of conduct.

Let’s further examine this idea of a written code of conduct. 

L.L. Bean Inc., is a good example of a company working hard to preserve the earth’s precious resources as well as human rights via labor laws and product sourcing while maintaining a profit. Their code of conduct consists of Corporate Citizenship and Social Responsibility.

Please visit the L.L. Bean website to learn more about their business ethics.

So what does that mean to you if you were working in the finance division of L.L. Bean? Well, it might mean that you would avoid investing in other companies or perhaps electing not to expand manufacturing facilities if that expansion would be been damaging to the envioronment.

A company's written code of conduct might not be a handbook entitled Our Written Code of Conduct. Rather, it might be composed of several handbooks describing and examining the company’s ethical position on many of society’s shortcomings.

Introduction to the How the Market Works Investment Challenge

Throughout the duration of this course, you will be participating in a team investment challenge. The investment challenge is your opportunity to see if you and your team have what it takes to be “players” on Wall Street. Together with your teammates, you will apply the principles of investments to a “real-life” investment situation, buying stocks to create a team portfolio. This will require you to develop an investment strategy and is designed to introduce you to investing in equities by establishing an active equity portfolio.

Your performance will be compared to other teams, the S&P 500 and the instructor’s portfolio. There is no right answer for this assignment; each of you will define your own team’s return objectives and risk tolerance and describe your strategy. Teams will have $100,000 to invest in at least five common stocks over the course of the game.

The game is designed to be a learning experience. Students will be required to relate investment theory covered in the course and discuss it in their performance memos. Your grade will depend on the quality (not quantity) of your performance reports and not your actual performance of your portfolio. First Memo and Midpoint Performance reports should be no more than one page of text, plus tables and attachments if desired.

In addition to having fun, we will apply theory to practice. You will learn valuable insights that can be applied in your personal and corporate investments. Hopefully lessons learned in this game will allow you to make more informed decisions when some day you will be responsible for managing your own investments for retirement.

Steps and Points in the Investment Challenge Grading (50 points total)

As previously mentioned, the How the Market Works Investment Challenge spans the entire course. You should have received an e-mail from your instructor providing you with the link to the How the Market Works exercise and the specific team to which you have been assigned. This e-mail and the How the Market Works Web site itself provides you with a lot of details on how to purchase stocks.

In addition to this information, let's also review the major milestones for this project. There are four milestones where your team will be required to provide updates. Click on the tabs to learn about each milestone and its associated point value.

In addition to the points referenced above, you can also earn five bonus points for beating the “benchmark” S&P 500 portfolio.

General Guidelines

Choose one individual to initially set up your team portfolio on How the Market Works and ensure that your team meets the minimum requirements stated below.

1. Go to the How the Market Works site for official challenge beginning and ending dates.
2. Invest at least $20,000 by the second Monday of the course (beginning of Lesson 2).
3. Be fully invested; $100,000 for at least one week.
   (This does not mean that you need to hold the same stocks for that period, but if you sold a stock you would need to immediately buy another stock. For example, you could meet both of these requirements by investing $100,000 in five stocks on the first day of the game and selling these same five stocks on the last day of the game—simple buy and hold strategy).
4. Additional trades are encouraged.
5. You will decide as a team how much money to invest in each transaction.
6. You must complete a minimum of 10 trades (buy five stocks and sell five stocks). Buying and selling the same security counts as two trades. You will lose five points for each trade under the 10-trade minimum.
7. You can make as many trades as How the Market Works allows.

Using the Library Resources

As you begin your work with your teams, consider the resources available to you via the Library. The Library System here at Penn State is a tremendous resource available for you to use when conducting research. A link to the library and finance librarians is located on the left-hand navigation menu on your screen.

One resource in particular may be of interest to you and your teammates is Yahoo's Stock Screener. This Web site, previously referenced, is a stock selection screener provided by Hoovers.com that allows you to put in your criteria.

Lesson 1 Wrap-Up

Congratulations—you made it through Lesson 1 of Finance 301!

This lesson introduced you to the world of finance. Financial markets play a very important role in our society helping individuals and institutions make choices regarding the consumption and savings for future consumption. You also reviewed the different types of business organizations, defined the main goal of corporations, discovered how financial markets can benefit society, defined an agency relationship, distinguished between the primary market and secondary market, discussed why ethics is important in business, and finally reviewed the instructions regarding your group stock exercise.

Following is a brief overview of where you will be going from here in this course.

The course emphasizes hands on learning exercises that are designed to illustrate practical tools and techniques for understanding and applying the foundational concepts of corporate finance. Numerous examples are explained to help you understand how to use a financial calculator. Financial models are built in Excel spreadsheets to help understand how financial managers analyze financial statements, and projects. The lessons are organized into the following major topic areas.

1. The first section introduces finance to help you understand important accounting and financial analysis issues in corporate finance. The tools of common size and ratio analysis are described and incorporated into Excel spreadsheet models to provide valuable insights for managers, creditors, and investors regarding the strengths and weaknesses of a corporation.
2. Financial models are built from a solid foundation of the basic concepts of time value of money (TVM). TVM concepts are introduced with the use of a financial calculator and Excel spreadsheets. These concepts are included in analyses of real world financial issues such as valuing annuities and lump sum cash flows, creating a loan amortization schedule, and calculating the value of corporate bonds.
3. Next, the tradeoff of risk and return in financial models is developed. These concepts are then used to build models that value common stock and capital budgeting projects. The tradeoff of risk and return, diversification principles, and calculation of weighted average cost of capital (WACC) are important foundational concepts in finance that are applied in corporate finance as well as other broader areas of finance including personal finance and investments. 
4. Lastly, capital budgeting techniques are presented with an emphasis placed on the net present value (NPV) and internal rate of return (IRR) techniques. These techniques require a thorough understanding of cash flow analysis that includes the ability to identify relevant cash flows in a capital budgeting analysis. Common practical examples of replacing equipment, introducing new product lines, and implementing cost savings projects are demonstrated.