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Chapter 1

An Introduction to the Foundations of Financial Management

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Learning Objectives

Identify the goal of the firm.

Understand the basic principles of finance, their importance, and the importance of ethics and trust.

Describe the role of finance in business.

Distinguish between the different legal forms of business organization.

Explain what has led to the era of the multinational corporation.

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The goal of the firm

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The Goal of the Firm

The goal of the firm is to create value for the firm’s owners (that is, its shareholders). Thus the goal of the firm is to “maximize shareholder wealth” by maximizing the price of the existing common stock.

Good financial decisions will increase stock price and poor financial decisions will lead to a decline in stock price.

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Five PRINCIPLES THAT FORM THE FOUNDATIONS OF FINANCE

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Principle 1: Cash Flow Is What Matters

Accounting profits are not equal to cash flows. It is possible for a firm to generate accounting profits but not have cash or to generate cash flows but not report accounting profits in the books.

Cash flow, and not profits, drive the value of a business.

We must determine incremental or marginal cash flows when making financial decisions.

Incremental cash flow is the difference between the projected cash flows if the project is selected, versus what they will be, if the project is not selected.

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Principle 2: Money Has a Time Value

A dollar received today is worth more than a dollar received in the future.

Since we can earn interest on money received today, it is better to receive money sooner rather than later.

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Principle 2: Money Has a Time Value (cont.)

Opportunity Cost – It is the cost of making a choice in terms of next best alternative that must be foregone.

Example: By lending money to your friend at zero percent interest, there is an opportunity cost of 1% that could potentially be earned by depositing the money in a savings account in a bank.

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Principle 3: Risk Requires a Reward

Investors will not take on additional risk unless they expect to be compensated with additional reward or return.

Investors expect to be compensated for “delaying consumption” and “taking on risk.”

Thus, investors expect a return when they deposit their savings in a bank (ex. delayed consumption) and they expect to earn a relatively higher rate of return on stocks compared to a bank savings account (ex. taking on risk).

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Principle 4: Market Prices Are Generally Right

In an efficient market, the market prices of all traded assets (such as stocks and bonds) fully reflect all available information at any instant in time.

Thus stock prices are a useful indicator of the value of the firm. Price changes reflect changes in expected future cash flows. Good decisions will tend to increase in stock price and vice versa.

Note there are inefficiencies in the market that may distort the market prices from value of assets. Such inefficiencies are often caused by behavioral biases.

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Principle 5: Conflicts of Interest Cause Agency Problems

The separation of management and the ownership of the firm creates an agency problem. Managers may make decisions that are not consistent with the goal of maximizing shareholder wealth.

Agency conflict is reduced through monitoring (ex. annual reports), compensation schemes (ex. stock options), and market mechanisms (ex. takeovers)

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Discussion: The Global Financial Crisis

What factors contributed to the global financial crisis?

What do we mean by subprime loans?

How are mortgages securitized?

How have unemployment rates fared?

How can the financial crisis be explained using the five principles of finance?

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Ethics & Trust in Business

Ethical behavior is doing the right thing! … but what is the right thing?

Ethical dilemma -- Each person has his or her own set of values, which forms the basis for personal judgments about what is the right thing.

Sound ethical standards are important for business and personal success. Unethical decisions can destroy shareholder wealth (ex. Enron scandal).

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The role of finance in business

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The Role of Finance in Business

Three basic issues addressed by the study of finance:

What long-term investments should the firm undertake? (Capital budgeting decision)

How should the firm raise money to fund these investments? (Capital structure decision)

How to manage cash flows arising from day-to-day operations? (Working capital decision)

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The Role of Finance in Business (cont.)

Knowledge of financial tools is relevant for decision making in all areas of business (be it marketing, production etc.) and also in managing personal finances.

Decisions involve an element of time and uncertainty … financial tools help adjust for time and risk.

Decisions taken in business should be financially viable … financial tools help determine the financial viability of decisions.

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The legal forms of business organization

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The Legal Forms of Business Organization

Business Forms

Sole

Proprietorship

Partnership

Corporation

Hybrid

S-Type

LLC

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Sole Proprietorship

Business owned by an individual

Owner maintains title to assets and profits

Unlimited liability

Termination occurs on owner’s death or by the owner’s choice

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Partnership

Two or more persons come together as co-owners

General Partnership: All partners are fully responsible for liabilities incurred by the partnership.

Limited Partnerships: One or more partners can have limited liability, restricted to the amount of capital invested in the partnership. There must be at least one general partner with unlimited liability. Limited partners cannot participate in the management of the business and their names cannot appear in the name of the firm.

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Corporation

Legally functions separate and apart from its owners

Corporation can sue, be sued, purchase, sell, and own property

Owners (shareholders) dictate direction and policies of the corporation, oftentimes through elected board of directors.

Shareholder’s liability is restricted to amount of investment in company.

Life of corporation does not depend on the owners … corporation continues to be run by managers after transfer of ownership through sale or inheritance.

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The Trade-offs: Corporate Form

Benefits: Limited liability, easy to transfer ownership, easier to raise capital, unlimited life (unless the firm goes through corporate restructuring such as mergers and bankruptcies).

Drawbacks: No secrecy of information, maybe delays in decision making, greater regulation, double taxation.

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Double Taxation Example

Assume earnings before tax = $1,000

Federal Tax @ 25% = $250

After tax income available for distribution to shareholders = $750

Compute the taxes if the company chooses to distribute the entire after-tax profits to shareholders as dividends.

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Double Taxation Example

If corporation distributes profits as dividends to shareholders, shareholders will be taxed again.

Assuming dividends are taxed @ 15%

Dividend tax = 15% of $750 = $112.50

==>Total tax = 250 + 112.5 = $362.5 or 36.25%

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Hybrid Organizations: S-Corporation and Limited Liability Companies (LLCs)

S-Type Corporations

Benefits

Limited liability

Taxed as partnership (no double taxation like corporations)

Limitations

Owners must be people so cannot be used for a joint ventures between two corporations

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Limited Liability Companies (LLC)

Benefits

Limited liability

Taxed like a partnership

Limitations

Qualifications vary from state to state

Cannot appear like a corporation otherwise it will be taxed like one

Hybrid Organizations: S-Corporation and Limited Liability Companies (LLCs) (cont.)

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Finance and the Multinational Firm: The New Role

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Finance and The Multinational Firm: The New Role

Coca-Cola, among other companies, receive significant profits from overseas sales.

U.S. firms are looking to international expansion to discover profits.

In addition to U.S. firms going abroad, we have also witnessed many foreign firms making their mark in the United States. For example, domination of auto industry by Toyota, Honda, Nissan, and BMW.

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Review: Key Terms

Agency problem

Capital budgeting

Capital structure decisions

Corporation

Efficient market

Financial markets

General partnership

Incremental cash flow

Limited partnership

Limited Liability Company (LLC)

Partnership

Opportunity cost

Sole proprietorship

S-corporation

Working capital management

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