1 chapter 1 introduction to financial management key sections: –what is financial management?...
Post on 22-Dec-2015
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Chapter 1Introduction to Financial
Management• Key sections:
– What is financial management?– Legal forms of business– Principles of taxation– Shareholder wealth, not profit, maximization is goal– The ten principles of financial management
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What is Financial Management?
• Tools and decision making processes to maintain/create economic value and shareholder wealth
• What investments to make and how to finance them
• Allocation of scarce resources based on uncertain costs/benefits
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Goal of the Firm
• Maximize shareholder wealth
– Measured by market value of stock
– Includes effect of all financial decisions
• Shareholder wealth max profit maximization
– PM ignores risk/timing of cash flows
– Increase current profits by cutting R&D and maintenance??? (Probably not good idea)
• How should stock price be affected?
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Legal Forms of Business
• Proprietorship – unincorporated, one individual, personally responsible for all its debts and losses
• Partnership – two or more co-owners governed by an agreement– General partnership – each partner fully liable
– Limited – one GP and LP’s with limited liability
– Various other types of partnerships
• Corporations
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Corporations
• Composed of owners (shareholders)– Elect directors who appoint managers– Function separately and apart from owners
• Shareholder’s maximum loss – amount paid for shares
• Advantages: limited liability, transferability, funding availability, no upside limit on potential
• Disadvantages: double taxation, expensive to form
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Taxation
• Our emphasis – how taxes affect decisions through expense deductions
• Taxes based on profits: sales and other income less allowable expenses and exclusions– Cost of producing, marketing, admin expense,
depreciation and interest (but not dividends)
• Progressive rates – more earned, higher the marginal rate– Marginal, not average, rate relevant
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Other Tax Considerations
• 70% of dividends from another corporation excluded from taxable income (sometimes 100%)
• Depreciation – asset’s value expensed over its life– Different methods used – total expense the same but
not the timing
– Often straight line for financials, accelerated for taxes
• Capital gains/losses – taxed as ordinary income for corporations; cap gains and dividend taxes recently changed by Congress for individuals
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Tax Implications
• Measure returns on after-tax basis using marginal, not average, tax rates
• Taxes affect capital structure – interest, but not dividends, tax deductible
• New tax law: for individuals both dividends and long-term capital gains taxed at 15%
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The Ten Principles
• These are statements of common sense– Provide logic behind rest of this course
• #1 Risk/return tradeoff– Won’t take additional risk unless compensated; we
are risk adverse
– Greater risk, greater expected return
– Key concept in valuing all assets
– Almost every decision involves tradeoffs
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Risk-Return Relationship
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# 2 Time Value of Money- TVM
• A dollar received today is worth more than a dollar received in the future
• Earn more interest on money received sooner
• Brings future benefits and costs back to present time – makes them comparable
• Assumes cost of money determined by risks and returns (more risk, higher returns)
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#3 Cash, not Profit, is King
• Can only use cash flows, not profits– Cash, but not profits, can be reinvested
• Accounting profits shown when earned; cash flows occur when collected
• Capital expenditures occur immediately; accounting records depreciation over many years
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#4 Incremental Cash Flows(Only what changes counts)
• Think incrementally.
• Will the project make a difference?
• Not all cash flows are incremental– New product may cannibalize an old product
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#5 Curse of Competitive Markets
• Hard to find exceptionally profitable projects• Large profits attract new competitors• Can’t last long if markets competitive• Barriers to entry and product differentiation
– Brand name, service, quality, patents, advertising
– Cost advantages – economies of scale, proprietary technology, etc.
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#6 Markets Assumed Efficient
• Values fully reflect all available information at any point in time
• You can’t expect to beat the market
• Efficiency determined by speed new info is reflected in prices
• Market prices reflect expected cash flows
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#7 Agency Problems
• Management won’t work for owners unless it is in their interest
• Arises from separation between decision makers and owners (“the corporate jet problem”)
• Why isn’t management fired if don’t act in shareholders’ interest?
• Need to align interests (monitoring, auditing, options, bonuses)
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#8 Taxes Bias Business Decisions
• Must consider after-tax incremental cash flows
• Tax incentives – deductions and credits (R&D spending)
• Interest – a deductible expense; dividends not deductible; may affect capital structure
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#9 Not All Risk Is Equal
• Some can be diversified away, some cannot
• Diversification – multiple investments; reduces risk– One investment’s gain offsets another’s loss
• Reduces total variability without reducing returns (providing returns don’t move together)
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Reduce Risk - Diversify
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#10 Ethical Behavior“Doing the Right Thing”
• Ethical errors are NEVER forgiven
• Unethical behavior eliminates trust– Without trust, companies can’t interact
• Loss of confidence in company’s ethical behavior – extremely damaging
• Social responsibility – goes beyond shareholder wealth maximization
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Multinational Corporations (MNC’s)
• Operations in more than one country• Began after WWII devastation; accelerated
by fall of communism, acceptance of free markets, and information technology
• Coke earns more in Japan than in US; Dow, Colgate, 3M, HP more than half profits from overseas
• Many US firms owned by foreign interests