Excel Finance Class 08: Intro To Corporate Financial Management

Welcome to Finance in
Excel video number 8. We're in chapter
1, and this chapter will be unusual in
that we don't have any Excel Workbook to download
and do financial calculations. We're just going to
define some terms and talk about some concepts. Hey, this last
chapter, chapter 0, we talked about the
basis of Excel in math. Now we're going to
talk about finance. Now, this is a file– a PDF. And you can download this
by clicking on the link directly below the video. If you're in the class, just
go to our class website. Now finance, this is an
exciting time to study finance. Why? Because we've just had
a financial meltdown– 2007. Still to this day, 2010,
we see the repercussions. In essence, the
financial markets, banking, financial
engineers, creating things like credit default swaps,
took capitalism and the banking industry for a ride.

And the exciting– I mean,
we got into a lot of trouble. The banks and everyone
lost a lot governments unfortunately came in and
rescued some of these banks. So some of the people involved
may have received lots of cash when they probably
shouldn't have. Nevertheless, what's exciting
about this moment in history is that it's a fulcrum point. Moving forward, we do not know
what the future of finance will be. It will be different
than it was in the past. And although this
class is mostly a real basic math-oriented
class, some of the questions that people are asking right
now in the field of finance– ever since August
2007 when this first hit, and then in the
later part of 2008 when Lehman Brothers
went bankrupt, AIG, and other companies
in the United States got taken over basically
by the government.

Ever since then, people
have been rethinking things. And some of the questions
they're asking are, do free markets really
allocate resources efficiently? Which means, do free
markets really work? Are markets efficient? Later in this class,
we'll actually get to talk about
this a little bit. This one, we don't talk about
much these in this class. But these are
questions that people assume they have the
answer for for years in finance and economics.

But now people are
really questioning these. And do people act rationally? A lot of times in
economics, they just assume that people make
rational decisions. So the reason why
finance is exciting, even in this basic
class where you don't get to talk
about these things, is because these
questions are being asked. And the answer to them– coming
who knows when in the future– will define the
future of economics.

All right, chapter
1, we're going to talk about these topics. Why corporation is an
efficient business form. We'll talk about the
structure of a corporation. We'll talk about the fundamental
accounting equation– assets equal liability plus equity. Define finance, talk about the
goal of financial management. We'll also talk about why
should we study finance in the first place. This is an intro
class, and some people are absolutely never going
to be finance managers. But they're taking this class. What are key questions
to ask in finance? Talk just momentarily
about financial markets a lot more later in the
book, and cash flow.

All right, now, another
thing about this video. You probably want to hit
the Full Screen button. In most of the other videos,
you could have it small and you can see everything. But in this video, it's going be
kind of hard to see everything unless you make the screen big. Forms of business. There's all sorts
of different forms, but the basic ones are
sole proprietorship– hey, just one person owns a
company– partnership– more than one person– and corporation. Here's some of the aspects
of a sole proprietorship. It's easy to start. You just start one. Least regulated. It is hard to raise
funds, though. Imagine if you go to
the bank and say, hey, can I borrow some money? Whereas if you're
a big corporation, you have an easier
time getting funds. Big, huge drawback–
unlimited liability. All this means in a nutshell
is if you get sued– remember, sole proprietorship– not only
can the person suing you take your business assets– means all the cash and things
you have for your business– but they can also take
your personal assets. Advantage– ding ding,
sole proprietorship– single taxation. You just get taxed on
whatever your income is.

Difficult to sell ownership. Hard to sell a sole
proprietorship. Whereas if you think of a
corporation that has stock, you can just go sell your stock,
if you have Microsoft stock. Partnerships, very similar
to a sole proprietorship. General means you invest and
work for the partnership, limited means you just invest. Easy to start,
somewhat regulated. Somewhat hard to raise funds. Maybe a little bit easier than
a partnership, because you have more than one person. Same problem with a
sole proprietorship– unlimited liability. You get sued, they can take
all of your partner assets and your personal assets. Advantage, single taxation. Difficult to sell
ownership also. Now, unlimited liability. So then comes along
the corporation. And instead of having an
individual and a business, you just create a
separate legal person.

Now, there's lots of
paperwork you have to file. It's somewhat hard to start,
and it can be heavily regulated. But once you have
this corporation, the owners can
invest their money. And if anyone sues
the corporation, the corporation will lose all
of their corporate assets– meaning all the cash,
buildings, everything like that. But they can't come
after the owner. C corp means a big corporation
like Microsoft or Whole Foods Market International. S corporation is a
small corporation. Limited liability
company is actually an invention that's like a half
corporation and half partner. The advantage to a
limited liability company is you get the protection,
which I just talked about.

It's called limited
liability, which means if the
corporation gets sued, you lose just the assets
from the corporation, not the owner's assets also. So if you own stock in Microsoft
and then Microsoft gets sued and they go bankrupt, they
can't come and take your house. So the advantage of the
limited liability company is it's got that aspect
of the corporation. Ah, but it says half partner. Single taxation. So it's got limited liability. The limited liability company
has the limited liability advantage of the corporation,
but the advantage also of single taxation
of a partnership. Oh, big problem. Double taxation for
the corporation. That means whatever
your income is, you're going to
get taxed on that, and then you're taxed again
when you pay out a dividend.

Now, later we'll
talk about dividends. But dividends are just when
the company pays out cash to the stockholder. You have to pay taxes on that
also, so double taxation. Easy to sell stock,
because once you buy– in fact, I could just
go to the last slide and cover this one first. Here it is, page 13 in
this downloaded PDF. Financial markets. There's primary markets
and secondary markets. But get this– when Microsoft
in the primary market issues a stock, you may buy it. But Microsoft gets the cash. So original sale of the stock. When you sell the
original one, the cash comes into the corporation. So the corporation is
issuing the security. That's another word for stock. And then Microsoft
gets the cash. Secondary market means
you the owner– now you have that stock.

You can go to sell it
to anyone you want, and that's called
the secondary market. So after the
original sale, owners can buy or sell the equity– the stock, or later we'll
learn that there's debt also– debt instruments. You can sell them in
the secondary market. You buy or sell the security. Here it is, the primary market. Here's Microsoft, so you
give them some money, and they give you a stock. You are a new owner. But in the secondary
market, you can just go sell this Microsoft
stock to whoever else. Secondary market. Let's see. Whoops. All right, so easy
to sell stock. Now, there is a reason
that this class is mostly about corporate finance. By the way, we're studying
corporate finance, but most of the math
and cash flow tricks and financial statement
analysis that we talk about can be used by anyone– not
just a corporation, a nonprofit, or an individual or
a sole proprietor.

But we're studying
corporate finance. And we want to
just briefly think about why the corporate form
is better than sole proprietor or partnership. Well, we already talked about
limited liability, right? If you get sued, they only take
their corporation assets, not your house, if
you're a stock owner. But the main idea is, if
you have a good idea– you're an entrepreneur, you
want to start a business– the corporation is great because
you have access to funds. That means you can get money
to create your business that's going to create this good idea. Whether it's a new product,
like the iPod, or a new service industry or whatever. Your good idea– if
you have a good idea, the corporation is
really excellent. And the reason it's most
efficient, because you can get funds quickly. Equity or debt, it says here. Equity just means stock. And we'll talk about the
fundamental accounting equation in just a moment. Debt means you take out money.

But if you have a good idea
and you have a corporate form and you're well
established, it's easy to get funds to
do whatever you want. And here's these reasons again. But at the top,
easy to raise cash. Of course, the
limited liability, ease of transferring ownership
in the secondary market, and unlimited life. Sole proprietor dies,
the business dies. If you die with some Microsoft
stock, Microsoft doesn't die. The stock goes to
whoever you left it to. All right, structure
of the corporation. Since this class is
about corporate finance and corporations seem
to be efficient in terms of getting funds, we have
stockholders at the top. So you own the stock. When you own a stock,
you are the owner. Owners vote and bring
in a board of directors. The board of directors,
then, hires the managers.

And the managers are inside the
company running the company. Now in general– see
the arrows like that? So it goes, owner
decides everything. Owner votes these guys in,
who then hire managers. If these guys–
board of directors– hire managers you don't
want, what do we do? We get rid of them. But in the real world, it
doesn't always work that way. The managers oftentimes
take control of everything, including picking their
own board of directors. So sometimes, it goes this way. Nevertheless, this
is the structure. Doesn't always play out
that way– structure of the corporation. All right, finance class, right? Here's board of directors. And then here's
inside the company. Where does finance happen? Here's CEO, Executive Officer;
COO, Operating Officer; CFO, Finance Officer. There's also a CIO. In the information age, we have
Chief Information Officers. More and more as
history unfolds, being able to get
good information and use it for business
decisions is very important. Ah, here's the comptroller. Look at this,
accounting down here. Here's the treasurer. Finance is almost always
in the treasury department.

Cash manager– manage cash flow. Cash flow is going to be very
important in this finance class. Credit manager. Do we extend credit
to our customers? Capital expenditures. Oh, we'll have lots of fun in
this class trying to figure out what projects a business
might choose to engage in or what businesses to buy
or what machines to buy using cash flow analysis. And financial planning–
do we issued debt or stock, and other topics. So treasury, that's
where we have all of our exciting finance topics. Now, fundamental
accounting equation. let's see if I can
get this right. Whoops. Can you read– that's
better there, no? no, no. There we go. All right, fundamental
accounting equation– assets equal
liabilities plus equity. No problem. If you have had accounting,
you know this by heart. This has been around
for 600 years. All of accounting
and all of finance basically uses it to this day. Now, what does it mean? If you don't know, just
look at the picture, right? These pictures can
explain it perfectly. If you have a house, $200k. If you pay $200k,
then its assets equals equity, because
you own everything.

But most of the time,
it's not like that. You go out and you get a loan. Liability just means D-E-B-T– debt. You owe. So you go out and borrow $150k. That means the bank
really owns your house. And then you put $50k down. That's all this equation
means, and we'll be using this all the time
in this finance class. When you buy an asset– a house, a truck. Imagine UPS, a brown truck. They're buying that brown truck.

They're buying buildings. Businesses are buying
other businesses. Even inventory,
they're all assets. So get this– if a
business all of the sudden has a great new idea and
needs some new machines, well, they need cash to go
and buy that machine, right? Well, they can get cash two
places– boom, boom, boom, boom. And so that's the
liability and the equity. So if you have a new good idea
or some asset you want to buy, you can either do it with debt,
equity, totally debt, totally equity, or some combination. That's what this equation means. Now, assets– things you own,
like cash, truck, building patent.

The accounting
definition in GAAP is something like provide
probable future economic benefit. Now, all that means is
if you have the brown UPS truck, future economic benefit. It means you're going
to deliver the stuff and the customer is
going to give you cash. The economic benefit is
ultimately some income. Probable just is
because you could crash the truck or the
building could burn down.

Provide– so assets
always provide probable future
economic benefit. Liabilities, just D-E-B-T.
That's all you need to know, debt. That means you owe, we owe,
whoever it is, they owe. By the way, later we'll talk
about there's a flipside. Anytime someone owes, the
person on the other side– the flip coin is an asset. So if you borrow money,
you are the borrower. The lender, on the
other side, of course, has an asset, because
you owe them the money. But we'll do more on that later.

All we're talking
about is liabilities. That's when we borrow money. That means we owe, a contract
to pay back loan and interest. Bank gets paid– or
whoever it is, the lender– before you– I don't
think I wrote this right. Bank gets paid before
you when bankrupt. All it means is the
bank gets your house. If you default, the bank
gets paid first always. That is a contractual
obligation. The banker, the person who
loaned the company the money, gets paid first when
you go into bankruptcy. If anything's leftover,
you will get it. So if you default on this,
the bank has to sell it. If the bank sells
it for $100,000, that doesn't cover the debt. But that's all they get. The owner gets nothing. In business it's true also. So asset, liability, equity. Equity is just– if you're
thinking about liability as debt, just think about this
as whatever's left over after you pay all the bankers– whatever is leftover. I always think of it this way. Assets minus debt equals
equity, whatever is left over.

Not only on the
accounting records here, but in bankruptcy
that's also true. All right, the definition
of finance from this. Actually, they don't
give you a definition of finance in this textbook. In essence, they
leave the goal of corporate financial management
kind of as our definition of finance. But I'm going to
give you one here. How to allocate scarce resources
across assets over time in order to earn a return. That's the definition
of finance. You can go Google it and look
up 10 different definitions, and they're all some
variation of this. Now, what this means is, first
off, what should we invest in? If you're an
established business, should we go and
get this machine, or should we go
and buy this truck, or should we try to buy
a different company? What should we invest in? That's the asset
part of this, how to allocate scarce
resources across assets.

What are we investing in? Second, should we
use cash, equity– I mean, I shouldn't say cash,
but just equity or debt. Your cash can come
from equity or debt. But that's an
important question, because you can go
out and issue stock or you can go out and
issue some debt, right? This is the allocate
scarce resources. Now, you can't go out and just
get as much equity or debt as you want. So the word scarce is there. But scarce resources– really,
that's the equity and debt you have. So how do you allocate? How do you take all
that capital you have– the either debt or equity? How do you take all of that
and decide which assets to buy? Now, this definition then
says, across assets over time. And here's really one of the
troubling aspects of finance. It's all about the future.

And the future is unknown. So this makes finance
difficult. Really, you're always looking
into the future and making lots of estimates
and deciding what to do. All right, the goal of
corporate financial manager. This is straight
from the textbook. And this is the
same thing they've been teaching for 30 years. Basically, every
textbook you ever see says, the goal of
financial management is to maximize the current value
per share of existing stock– or market value of equity. Because big companies
can trade their stock. So current value per
share of existing stock. But also, market
value of equity, even if it's a
small business, it's still whatever that
equity is worth. It's just on a small
business sometimes, it may be hard to
get a market value, because we really don't
know what something's worth until you sell it.

Now theoretically,
this is a good goal, since the owners
own the company. Now think about this. If you're inside the company
and you're a financial manager and you're trying to figure
out what assets to buy and how to finance
everything, really, you are working for the owners– for the stockholders,
for the owners. So you always act in
their best interest. And if the market value
of the equity goes up, that's a good thing. So theoretically, this
is just the perfect goal. However, there's
lots of problems. Well, let's look
at a few of them. There's something called
the agency problem. And the textbook actually
talks about this. By the way, I mention these
hot topics here in finance that people are
debating historically. This book really
doesn't talk much about what's happening right now. This book is still kind
of the old school finance before our financial crisis.

And in a few years, we might
have a slightly different definition in our textbook. This textbook, however, does
talk about the agency problem. And agency just
means– you've got a stockholder and
a manager, right? Stockholders are
called principal, managers are called
an agent, right? An agent works for someone else. They work for the principal. So agent works for
principal, which means the managers are
working for the stockholder. Agent– meaning the managers– are supposed to act in the
best interests of the principal or the stockholders. But here's the problem. The agent is inside the business
and has custody of the asset. Managers are here. Here's a picture, right? And the owners are out
here with their stock. How in the world, if
they're always out here, and managers just doing
everything every day, not only are they
making decisions, they are in control of the
assets and the accounting and everything.

So there's a problem here. How do you get these guys here
to act in the best interest? So the agency problem. And this book talks about it. And really, the ethical– managers do not always
act ethically or legally. Now, in the case
of Enron and some of the great
spectacular crashes, there was just massive
illegal activity. But what about ethically? What about AIG? AIG did credit
default swaps, which were perfectly legal, right? But it was clear in hindsight
that this was not a good idea. It could only lead to the
collapse of the banking system. So even though it was legal
to do this, was it ethical? Very difficult problem when you
have managers inside and owners outside. Now, some of the ways you can– I'll skip down here to this one. So the question is, if
the principal is not watching the agent 100% of
time, how does the principal get the agent to act in the
best interests of the principal? Well, the way that most
textbooks and most theory used to work is you say, pay the
managers based on stock value.

Well, what does that do? That makes the manager
exactly like an owner. So if their pay is based on
stock value, when it goes up, then the manager gets more. There's a couple
problems, right? The one that's happened just
throughout all of history is then the managers
cook the books. That's a cliche to describe that
they're making the accounting look good so the
stock value goes up so they get their bonuses. But currently in
finance, there's no definitive answer to this. But this is coming
into question a bit. But in theory, it
certainly is a good idea, because it makes the
manager like the owner.

Other even better ways,
external auditors. So external auditors are– if we look at this picture– oh,
I should have drawn a picture. They're the auditors. They're accountants that come
in and go through all the books. Because somehow, we've got to
get the financial information in here out to the
owners and the government and potential investors. So the auditor comes
in and audits them. Now hopefully,
they're independent. Unfortunately,
again, recent history shows us some
problems with this. The external auditors at Enron– Andersen International– came
in to audit Enron, right? And they came in and they
said, everything's really good.

But it wasn't. Same with the financial crisis. The financial crisis, not
only the external auditors but the rating agencies
and lots of other people– the regulators from
the government– all fell down on the job. But in general, external
auditors really do tend to do– if you look at all
of auditing history– a good job of going in
and saying, hey look– if the managers inside
are cooking the books, the auditors generally
come in and say, you can't cook the books.

And then that way we get
good information out. Now, what does this mean? This says external
auditors report to the board of directors. That means, if we remember
our hierarchy here– so let's see if I can flip this. Board of directors,
so they're up here. So really, the auditors come
in and look at the managers, and then come out
and make the reports and then go to the
board of directors. That really is the
way it should be. That way if
something's going on, they tell the
board of directors. Let's see if I can flip this. Is that how I did it? OK, there we go. Another way is control
over assets and accounting. That means there are controls
before the managers ever get there that ensure
that custody of assets and all of the accounting is
done in accordance with rules and ethically and legally. Another way we get
managers to act in the best interests of the
principal, Sarbanes-Oxley Act.

A lot of things happened. This was in response
to the Dot-Com bubble. In the year 2000,
2001, the stock market went up and then crashed
dramatically– mostly all the Dot-Com companies. And so a couple of years later,
Sarbanes-Oxley Act came out. And one of the
things it did is it makes managers
personally responsible for the financial statements. So they actually have to sign
them and say, these are good. That way later if they
turn out not to be good, then they can come back
and say, ah-ha managers, you are personally
liable for that.

Another way is regulation,
like on insurance. And the insurance
industry, which is kind of a branch of
finance that we don't talk about in this class, really. But the regulators come in,
and if you're taking out car insurance, the
insurer has to hold money aside so that if you get in a
car accident, they can pay you. That's a good type
of regulation. So that kind of
regulation can really help the managers act in the
best interest of the principal. That always doesn't
happen, as we will see throughout
this class or talk about briefly on occasion. All right, problem number two. Remember, we're
talking about the goal of financial
management is simply to maximize current
value of stock. So maximize stock value. Problem number two. Financial, accounting
management gurus– all these are different. There's financial
gurus, accounting gurus, management gurus.

They always invent ways to
circumvent or circumscribe the law that protect the owners. Lots of examples
through history. I will just take the
two most recent ones. Lehman Brothers did this. They issued debt. So they go out, they say, I
want to borrow some money. And then it's listed
on the balance sheet as debt, which it should be. But then what did they do? They did these accounting tricks
where they actually bought the debt back and
recorded it as an asset, totally hiding the debt. Now, the thing is,
this was legal. It was not illegal to do this. But was it ethical? Because if all of a sudden
you're hiding debt– if the managers inside
are hiding debt, is that really good
for the stockholders outside of the business? So again, they did this
to circumvent laws. Because you're supposed to show
your debt on the balance sheet. And actually, there's
a lot of other examples of ways people hide
debt, both within the law and outside of the law.

Example two, financial gurus
invented credit default swaps to allow companies to
issue insurance policies without holding equity
in case the insurance had to be paid out. This is why AIG failed. This is in essence why
the financial system itself came to its knees
in 2007-8, et cetera. All they did was they invented
an insurance policy that circumvented the regulation. So AIG did not
have to hold money in case they had to pay off
their insurance policies.

And then of course, when
that system collapsed and they had to pay off all
these insurance policies, they had no money. But what happened there? The government came in and
helped AIG, which means us, the taxpayers. So circumventing the
existing regulations sometimes really does– even people who are
free marketeers and say no government
intervention– this is a clear example of we all,
even of us free marketers, we got hurt massively, because
there was no regulation. And they circumvented
the regulation using credit default
swaps, when they really should have just said,
hey, credit default swap, that's insurance, let's
put regulation on it. And the interesting thing
about AIG and Lehman Brothers is they're both dead,
basically because they tried to circumvent the law, and
it came back in the long run and caused Lehman Brothers
to cease to exist.

And AIG basically
lost 97% of its value and is floundering now, mostly
owned by the government. Problem number three
with our definition. The definition of finance
depends on financial markets being efficient. And all that means is
accurately pricing assets. But we had two bubbles. We had the Dot-Com bubble
and the housing bubble. Well, if there's bubbles, where
houses cost too much money– they're actually
charging a price that is more than what it's worth. Or in the Dot-Com
era, AOL or Webvan or many of the other
Dot-Com companies, they were worth a lot of money. The market was saying
they're worth a lot of money. The market was saying the
house was worth a lot of money.

But it turns out that they
weren't, because it crashed, and we could see clearly that
the houses weren't worth what the market originally said. So that says that
markets are not always efficient– which means they
don't always price correctly. Now, if managers are doing
things to maximize current market value, but the current
market value is not correct, the goal itself to maximize
current market value cannot be achieved, because the mechanism
to gauge whether decision is good or bad is broken. All this means is if
you're looking out into the market for
a price to tell you whether your decision
is good or bad. If the house price is blowing
up and you're looking out there you said, I better buy
this price so it goes up, not working efficiently.

The market is not
working efficiently, because the actual price
mechanism is broken. Here's an example. 2000 to 2010– I should
have put a 10 there. But here's the house price. Going up, going up. This is the market, right? So all of us are looking, saying
wow, look at that house price. I better get in and
buy it so it can go up and up and up forever, right? So we went looking through here. So we made our decision based
on a market price signal. House going up a
lot, I better buy it, so then I can sell it
later and make a profit. That signal was not accurate. Because what did it
do when it crashed? Everyone, we all
lost our shirts. And the price is still going
down, if you haven't noticed. This is 2010. You'd think, 2008-9, but
it's still going down. So this is an example. And by the way, that's
not spelled right. And why do I do these
handwritten notes instead of using PowerPoint? Mostly because
PowerPoint usually makes people fall asleep, so I
do my sloppy handwriting, which probably puts you more asleep.

But since there's no red line to
tell me when I misspell a word, like there is in PowerPoint,
some of the words might be spelled wrong. I'm sorry about that. All right, markets said the
houses were worth a lot. This is a price signal to
buy houses as an investment. Banks making the loans,
individuals buying the houses, and contractors
making the house, and lots of other people
like Home Depot, Lowe's, they were all opening new
stores, because everyone was doing houses. All of these people react
to that increasing price. But when the market
was incorrectly telling people to buy– so the market was actually
giving us an incorrect signal. So the point of all this is
that our original definition up here– way up here.

If only I had PowerPoint, then
I could just jump to the slide. So increase current
value of the stock. If the market itself
is not accurate, then that puts this
somewhat in question, whether we can use
it as our number one goal for financial management. All right, one last example. This is kind of banks only. You can look over
this one, if you want. Alan Greenspan in
congressional testimony said, those of us who have looked at
the self-interest of lending institutions– he's
talking about banks– to protect shareholder
equity, myself especially– Alan Greenspan's saying– are
in a state of shocked disbelief. All this means is
that they assumed that free markets and
individuals in the free market would never destroy all
of the shareholder equity.

And in essence, the
banking industry almost collapsed across the board. Specifically about banks. They just couldn't believe that
banks would implode completely when managers were allowed to
just do whatever they want. All right, next topic. We're going to study
corporate finance, but there are other
areas of finance also. Investing. You can be a stockbroker
picking stocks or a bond trader picking bonds. Equity, debt. Portfolio manager, managing
other people's money in a portfolio of stocks, like
mutual funds or index funds or all sorts of funds.

Or a security analyst. This is perhaps the
most interesting. This is where you do all the
research to pick the stock. Financial institutions is
another area where you talk– banks, insurance, investment
banks, institutions like that. And finally,
international finance– other areas of finance
that we're not going to talk about in this textbook. All right, why should
we study finance at all? Hey, personal– what
about student loans? What about credit cards? Again, this is a
corporate finance class, but we're going to see
awesome examples of credit cards, student loans,
all sorts of things that we everyday people have
to deal with all the time. How to make good decisions
about whether to pay the minimum payment
on a credit card.

We'll actually see calculations
that we can do in our own life from this corporate finance
class that can help us. What about you
making investments? What about retirement savings? We'll talk about that. What about banking? Careers. Basically, most endeavors
involve some aspect of finance. Marketing, you
have to do budgets. Not only that, in marketing, you
have to analyze a market plan. Which means if you
have a new product, you have to do
hard core finance. We'll learn later in this class
about cash flow analysis using net present value, a
mathematical technique to decide what
project to select.

But if you're doing marketing
and you're doing a new product, you better know how
to analyze a market plan using net present value. Accounting. Basically, you can't do finance
without knowing accounting. They're completely intertwined. Management. Remember, that's
this class, right? Financial management. What do you invest in? What projects are best? Job performance, meaning
aligning managers' incentives and interests with
stockholders by paying them based on a stock value. And personal finance– again,
this is corporate finance, but we'll see lots of personal
finance examples in this class. What questions to ask. This is our seventh topic. Capital budgeting,
all that means is what long term investments,
what assets do we buy? Equipment, buildings,
investments. Capital structure, is
it debt, is it equity, or is it our profits? Because guess what, when
the company makes profit, you keep it as equity, because
that's the owners', right? So really, when you're
doing capital structure, we're using new equity,
new stock, debt, or our internal profits.

And then working capital. This is the everyday nuts and
bolts of running the business, right? This is short term. Current assets,
current liabilities, we'll define those
terms next chapter– chapter 2. It just means the short term. In large part, your short term
cash coming in, cash going out. How do we collect
from customers? How do we pay our bills? Topics like that are concerned
with working capital. All right, we talked
about financial markets, primary, secondary. Now, cash flow. Let's talk about the cash flows,
because in finance, cash flows are everything.

But wait a second. If we have accounting
information that's not always cash,
it's accrual accounting, how are we going to do finance? Well, in chapter 2, we'll
talk a little bit about that. But here's the flow of
cash for a corporation. It says A, firm-issued
securities. So maybe in your
initial public offering, you issue a bunch of stocks. People out in the
financial markets, maybe we decide to buy some
stock from this company. So the cash goes this
way, into the business. We get the stock, right? Cash goes in. That's one flow of cash. Now, firm invests in assets. We talked about it. We buy assets, we buy
machines, buildings, and all that kind of stuff. What are we buying assets for? To get a return, right? So there's going to be C,
some cash from the assets. Not always. Especially in the early
years of the company, maybe you don't have a
lot of cash from assets, or the early months or
something like that.

But get this. It's going this way. But wait a second,
it diverts here. It goes three different places. Well obviously, especially
in the early years of the business, you want
to reinvest cash flows into your business to
buy more assets, right? If you have a good idea,
you want to keep it going. Some of it's going to go where? Back to the financial markets. Not only paying dividends,
but debt payments. Ah, and also some will go
to the government and other stakeholders in
the form of taxes– or maybe you even
make some donations– and other stakeholders also. Cash flows of the firm. It's all about the
cash flow in finance, not accounting numbers. All right, that's
it for chapter 1. I will, though,
however, take a break. And now I'm going to tell you
about AIG, just an analogy to understand how crazy it was
what was happening in the '90s and '80s when credit
default swaps were invented. Here's us. We have a car and we
want to buy insurance. So we buy insurance in
case we have an accident.

So let's just say
we give AIG $100. Insurance company promises to
pay if you get in an accident. So we get this little policy. Number one. Number two, oh, AIG
spends your $100 and does not save
any money at all in case you get in an accident. Now, they didn't actually spend
it, but they did get rid of it. They didn't keep any
money for your policy. Number three, AIG sells
1,000 more insurance policies to other people betting that
you will get in a car accident. Now, this is the hard part that
people usually don't understand about credit default swaps. We can understand this, right? You buy an insurance policy,
and if you get in an accident or something, they pay you. But what credit default swaps
allow you to do is AIG– there's 1,000 other
people looking at you, and they're betting that you
are going to get in an accident.

So they don't even have the car. They're not you. But they can still buy
an insurance policy called a credit default swap. So let's just say AIG
sells 1,000 other ones. So that means
1,001 people have– AIG should put a lot of
money aside to pay this off. All right, so here it is. Here's the total, $100,000. So it's $100 each that AIG gets. AIG spends this and does
not put any money aside in case we get in an accident. Now, they don't really
spend it, but they actually don't have it. They put it into other things. But they didn't put
any money aside. So government
regulators do not force AIG to put any money aside. Now, in the real car
insurance industry, they do. The regulars come
in and say, no AIG, you've got to put some
of the money aside.

And the regulator
says, hey AIG, I know that not everybody is
going to get in an accident. So maybe they make
them put aside a proportion of the amount,
so the people that do get in accidents can be paid. But in this example– this is a parallel example
of credit default swaps– regulator says, you don't
have to put anything aside. And then you get
into a car accident. You ask AIG to pay the $100. The 1,000 other investors
ask for their $100. AIG has no money. They cannot pay. That's a credit default swap. And that's what led to
our financial crisis. What happened with AIG for
the actual credit default swap wasn't car insurance,
it was just a loan. Here's a loan to ABC. Here's the lender. The lender goes
out and says, I'm going to buy insurance in case
borrower ABC can't pay me back. So buys insurance in case
borrower does not pay you back. Now, that's perfectly
all right, and a lot of the corporate credit
default swaps in the '90s worked kind of like that.

It was just an insurance
policy the lender took out. But now, 1,000 other people
buy insurance on the ABC, just like in the
earlier example, even though they did not
lend the money to ABC. And this was what happened
with all of our mortgage debt. People went out and
bet against people not being able to pay
off their mortgages. And again, it would
not have been bad if AIG just put money aside. But AIG spent all the money–
or put it somewhere– they got from the insurance policies. AIG did not put any
money aside, which is actually what happened, in
case ABC borrower does not pay. ABC does not pay, AIG has no
money to pay, everyone is hurt. That's what happened in
the financial crisis. Notice down here, I say,
except for government gives dollars to AIG to
pay off their contracts. And that's what they did. Us taxpayers came in and gave a
lot of money to AIG to pay off.

But AIG didn't have the money
to pay off the insurance. But the government– us the
taxpayers– gave money to AIG. All right, we don't get to
talk about credit default swaps and any of these
big heavy issues. But I thought in
chapter 1, I'd just give you an example too of
the current financial crisis. All right, next chapter– chapter 2– is going to be
all about financial statements and looking at
accounting numbers and then trying to figure out
cash numbers from accounting numbers. All right, see you next video..

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