UGBA 103

Firms, Cash Flows, Securities

Marcus M. Opp
Module I 01

© Marcus M. Opp 1 U.C. Berkeley

 Overview of Today
Today’ss Class

 Introduction to the language of the class

– Cash Flows
– Projects
– Firms
 Corporate Securities
– Common Stock (Equity)
– Preferred Shares
– Corporate Debt (Bonds)
– Derivatives

© Marcus M. Opp 2 U.C. Berkeley

 Course Resources for This Class

 Berk DeMarzo
– Chapter 1.
 Please do assigned readings before class

© Marcus M. Opp 3 U.C. Berkeley

 Definitions:
Cash Flows,
Flows Projects
Projects, and Firms

 Cash flow is an amount of money paid at a

specific time:
– C
Cashh inflow,
i fl positive
i i amount; or
– Cash outflow, negative amount.
 Project is a series of cash flows.
flows
– Cash inflows represent revenue.
– Cash outflows: initial investment and expenses.
 Firm is a group of projects.
– Role of management is to choose best projects.

© Marcus M. Opp 4 U.C. Berkeley

 Diagram

 Introduction to Language of Class

– Cash flow
– Project
– Firm
Series of
Project 1
Cash Flows
Firm
Series
S i off
Project 2
Cash Flows

© Marcus M. Opp 5 U.C. Berkeley

 Cash Flows and Projects:
Examples
 An entrepreneur starts a bicycle store.
– Initial investment is cash outflow ($500)
– Future net revenue is cash inflow ($1000/month,
($1000/month 24 months)
 An investor purchases a bank Certificate of Deposit (CD)
– Deposit is cash outflow ($10,000)
– Redemption
R d ti isi cashh inflow
i fl ($12,000
($12 000 in
i 2 years))
 A lottery ticket:
– Investment cost: Cash outflow of $1
– Jackpot: Cash inflow of $14,000,000 (with some probability…)
 So projects can range from real investments, to pure
monetaryy investments,, to ggambles ((the lotteryy ticket).
)

© Marcus M. Opp 6 U.C. Berkeley

 Cash Flows: Numbers with Dates

Bike Shop Bank Lottery

CD Ticket

Cash -$500 -$10000 -$1

Outflow

Cash $1000/ $12000 in 2 $0 or

Inflow month years $14 Million

Duration 24 2 Years 1 Week

Months

© Marcus M. Opp 7 U.C. Berkeley

 Cash Flows

 Whatever the source of the funds, finance only

concerns itself with the actual cash flows.

© Marcus M. Opp 8 U.C. Berkeley

 Starting a Business

 Assuming you have a good idea, how do you “start a

business”?
 Si l method:
Simplest h d just
j make k andd sell
ll your product,
d andd
report income on your personal tax return (Schedule C).
– Sole p
proprietorship
p p if one owner
– (General) partnership if more than 1 owner.
 Main disadvantage:
– Owner(s)
O ( ) personally
ll liable
li bl for
f all
ll bbusiness
i li
liabilities.
biliti
» Debts
» Law suits…

© Marcus M. Opp 9 U.C. Berkeley

 Other Organizational Forms
 Personal liability can be avoided by forming a corporation
(or limited liability company - LLC).
 This is pretty simple:
– File some forms, and pay c. $100 in fees,
– Open a bank account,
– Pay
Pa in money
mone to contribute
contrib te capital to the corporation and buy
b
“shares” (common stock or equity)
– … and you’re a CEO!
 The number
n mber of shares owned
o ned byb different people
determines their percentage ownership in the corporation.
 What’s the hardest part of starting a company?

© Marcus M. Opp 10 U.C. Berkeley

 Raising Additional Capital

 What if your firm needs more money than you

have available?
 Get money from someone else:
– Credit cards (Apple computer), or bank loans.
– Friends or family.
– Wealthy individuals, “angel investors”.
– E
Even wealthier
lthi venture
t capitalists.
it li t
– General public (IPO, secondary offering).

© Marcus M. Opp 11 U.C. Berkeley

 Raising Additional Capital –
Corporate Securities

 In most cases, raising money does not occur as a

gift…
 What
h must theh fifirm give
i away in
i return?
– Ownership/control
– Promises to make future cash payments – “securities”
securities
 The commonest securities issued include
– Common stock ((also known as shares or equity)
q y)
– Preferred Stock (sometimes convertible)
– Bonds

© Marcus M. Opp 12 U.C. Berkeley

 Comparison of Corporate
Securities

Common Preferred Bonds

Stock (Equity) Stock (Debt)
Ownership/ Owners of firm. Generally cannot No control except in
Control rights Hire/fire managers vote case of bankruptcy

Cash flows Dividends Dividends (fixed) Interest (fixed)

Tax status of cash Not deductible Not deductible Deductible

flows

Priority of cash Last in line Before equity, after First in line

flows all others.
others

© Marcus M. Opp 13 U.C. Berkeley

 Options and Derivatives

Definition:
fi i i A derivative
d is any security whose
h
value is derived from another security.

© Marcus M. Opp 14 U.C. Berkeley

 Options

 Call Option:
– Gives the holder the right to purchase one share at a
fixed price (usually called strike price)
 Put Option:
– Gives the holder the right to sell one share at the strike
 Type:
– E
European: Option
O i can only l be
b exercised
i d on some date
d
– American: Option can only be exercised on or prior to
some date (maturity date, say December 14, 2009)

© Marcus M. Opp 15 U.C. Berkeley

 Warrants / Employee Options

 Warrants are options issued along with other

securities (i.e. by a corporation, usually not
separately traded on exchange) such as convertible
bonds/ preferred stock:
– H
Holders
ld off convertible
ibl preferred
f d stockk have
h the
h right
i h
(but not an obligation) to convert their preferred stock
((bonds)) into a fixed number of the company’s
p y shares.
 Many companies offer some compensation in the
form of employee stock options

© Marcus M. Opp 16 U.C. Berkeley