ch01_1

An Introduction to the Foundations of Financial Management

– The Ties that Bind

Chapter 1

Keown, Martin, Petty - Chapter 1 2

Learning Objectives

1. Identify the goal of the firm.

2. Compare the various legal forms of business organization and explain why the corporate form of business is the most logical choice for a firm that is large or growing.

3. Describe the corporate tax features that affect business decisions.

4. Explain the 10 principles that form the foundations of financial management.


Slide Contents

1. The Goal of the Firm2. Ten Principles of Finance3. Legal Forms of Business

Organization4. Role of Financial Manager in a

Corporation5. Income Taxation

1. The Goal of the Firm


The Goal of the Firm

The goal of the firm is to maximize shareholder wealth.

Shareholder wealth is measured by share prices. Thus shareholder wealth maximization would imply maximizing the price of common stock.


Part of Coca-Cola’s Vision

“Maximizing return to shareowners while being mindful of our overall responsibilities.”— http://www.thecoca-colacompany.com/ourcompany/mission_vision_values.html(retrieved March 13, 2007)


Benefits of Maximizing Shareholder Wealth

Good corporate decisions are those that create wealth for the shareholder.

Society benefits as scarce resources are directed to the most profitable use by businesses competing to create wealth.


Share Price Changes (during last two years as of June 29, 2007)

Google: Share price increased by nearly $200 or around 67% (from around $300 to $500) … wealth created.

Yahoo: Share price decreased by nearly $8 or around 23% (from around $35 to $27) … wealth destroyed.


Why is Profit Maximization not the appropriate goal?

Profit maximization goal is unclear about the time frame over which profits are to be measured.

It is easy to manipulate the profits through various accounting policies.

Profit maximization goal ignores risk and timing of cash flows.

• Ten Principles: The Foundations of Financial Management

“…although it is not necessary to understand finance in order to understand these principles, it is necessary to understand these principles in order to understand finance.”


Principle 1: The Risk-Return Trade-off Would you invest your savings in

the stock market if it offered the same expected return as your bank?

We won’t take on additional risk unless we expect to be compensated with additional return.

Higher the risk of an investment, higher will be its expected return.


The Risk-Return Trade-off


Principle 2: The Time Value of Money

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

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


Principle 3: Cash—Not Profits—Is King In measuring wealth or value, we use

cash Flow, not accounting profit, as our measurement tool.

Cash flows are actually received by the firm and can be reinvested. On the other hand, profits are recorded when they are earned rather than when money is actually received.

It is possible for a firm to show profits on the books but have no cash!


Principle 4: Incremental Cash Flows

The 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.

This difference reflects the true impact of a decision.


Principle 5: The Curse of Competitive Markets

It is hard to find exceptionally profitable projects.

If an industry is generating large profits, new entrants are usually attracted. The additional competition and added capacity can result in profits being driven down to the required rate of return.

Product Differentiation (through Service, Quality) and cost advantages (through economies of Scale) can insulate products from competition.


Principle 6: Efficient Capital Markets

The values of securities at any instant in time fully reflect all publicly available information.

Prices reflect value and are right.

Price changes reflect changes in expected cash flows (and not cosmetic changes such as accounting policy changes). Good decisions drive up the stock prices and vice versa.


Principle 7: The Agency Problem

The separation of management and the ownership of the firm creates an agency problem. Managers may make decisions that are not in

line with the goal of maximization of shareholder wealth.

Agency conflict reduced through monitoring (ex. Annual reports), compensation schemes (ex. stock options), and market mechanisms (ex. Takeovers).


Principle 8: Taxes Bias Business Decisions

The cash flows we consider for decision making are the after-tax incremental cash flows to the firm as a whole.


Principle 9: All Risk is Not Equal

Some risk can be diversified away, and some cannot.

The process of diversification can reduce risk, and as a result, measuring a project’s or an asset’s risk is very difficult. A project’s risk changes depending on whether you measure it standing alone or together with other projects the company may take on.


All Risk is Not Equal


Principle 10: Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are Everywhere in Finance

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.

Ethics are relevant in business and unethical decisions can destroy shareholder wealth (ex. Enron Scandal).

• Legal Forms of Business Organization


• Legal Forms of Business Organization

Sole Proprietorship Partnership (General & Limited) Corporation Hybrid (S-Type & LLC)


Sole Proprietorship

Business owned by an individual

Owner maintains title to assets and profits

Unlimited liability

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


Partnerships Partnership: Two or more persons come

together as co-owners.

Two types of partnership: General or Limited


Partnership - General

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


Partnerships - Limited

One or more partners can have limited liability

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.


Comparison of Organizational Forms

Sole Proprietorship and General Partnership Unlimited liabilities Not as easy to raise capital

Limited Partnership Limited liability for partners


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. Shareholder’s liability is restricted to the

amount of investment in company. Life of corporation does not depend on

the status of its owners. Ownership can be easily transferred.


The Trade-offs: Corporate Form

Benefits: Limited liability Easy to transfer ownership 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


Double Taxation example

Income = $1,000Federal Tax @25% = $250After tax Income = $750

What will be the total tax if the company chooses to distribute the after-tax profits to shareholders as dividends?


Double taxation

If corporation distributes the profits as dividends to shareholders, shareholders will have to pay taxes on dividends.

Assume shareholders are taxed @20% on dividend income or 20% of $750 = $150

Total tax = 250 + 150 = $400 or 40%


Hybrid (S-Type Corporations)

S-Type Corporations Benefits

Limited liability Taxed as partnership

Limitations Owners must be people Can’t be used for joint ventures between

two corporations


Hybrid (Limited Liability Corporations - LLC)

Limited Liability Corporations (LLC) Benefits

Limited liability Taxed like a partnership

Limitations Qualifications vary from state to state

. Role of Financial Manager in a Corporation


The Role of the Financial Manager in a Corporation (figure 1.1)

HOW THE FINANCE AREA FITS INTO A CORPORATION


The Role of the Financial Manager in a Corporation (figure 1.1)

We focus on the duties generally associated with the treasurer and how investment decisions are made.

Role of finance in Business

Where to invest (capital budgeting decision)

How to raise money (Capital structure decision)

How to manage cash flows from daily operations (Working Capital decision)


. Income Taxation


Income Taxation Objectives:

Raise revenues for government expenditures

Achieve socially desirable goals

Economic stabilization


Types of Taxpayers Individual

Includes employees, self-employed persons, members of partnerships

Reports income on personal tax return Corporation

Reports its income and pays tax on profits Distributed dividends taxed to shareholders


Computing Taxable Income for Corporation

Taxable Income Gross income less tax deductible expenses, plus

interest income and dividend income Gross Income

Dollar sales from a product or service less cost of production or acquisition

Tax Deductible Expenses Operating expenses (marketing, depreciation,

administrative expenses) and interest expense

Dividends paid are not deductible


Computing Taxable Income ($000’s)

Sales $50,000Cost of Goods Sold 23,000Gross Profit $27,000Operating Expenses

Administrative Expenses $4,000Depreciation Expense 1,500Marketing Expenses 4,500Total Operating Expenses $10,000

Operating Income $17,000Other Income 0Interest Expense 1,000Taxable Income $16,000


Corporate Tax Rates

Income Rate$ 0 - $50,000 15%$50,001 - $75,000 25%$75,001 - $10,000,000 34%Over $10,000,000 35%

Additional surtax: 5% on income between $100,000 and $335,000 3% on income between $15,000,000 and

$18,333,333


Example: Computing taxes on taxable income of $16m

$50,000 * .15 = 7,500$25,000 * .25 = 6,250$9,925,000 * .34 = 3,374,500$6,000,000 * .35 = 2,100,000Surtax

.05*($335K-$100K) = 11,750

.03*($16m - $15m) = 30,000

Total Tax = $5,530,000


Marginal Tax Rates

Refers to the tax rate applicable to next dollar of income. In the previous example, the marginal tax

rate is 38% since $16m falls into the 35% tax bracket with a 3% surtax.

In financial decision-making, marginal tax rate is more relevant than average tax rate.

• Finance and Multinational Firm


Why do companies go abroad?

To increase revenues

To obtain cheaper resources (land, labor, capital, raw material)

To reduce the burden of government regulation (ex. Environmental laws, taxes, labor laws)

To increase global exposure


Risks/challenges

Country risk (changes in government regulations, unstable government, economic changes)

Currency risk (fluctuations in exchange rates)

Cultural risk (differences in language, traditions, ethical standards etc.)


Finance and the Multinational Firm U.S. corporations are looking to international expansion

to discover profits For example, Coca-Cola earns over 80% of its profits from

overseas sales

In addition to US firms going abroad, we have also witnessed many foreign firms making their mark in the United States (ex. the domination of the auto industry by Honda, Toyota, and Nissan)

International movement has been spurred by: Collapse of communism Acceptance of free market system developing in Third

World countries Technology and communication (PC’s and the internet) Improved transportation

ch01_1

Documents

petty chapter

riskreturn tradeoff

goal of maximization

expected cash flows

timing of cash flows

projected cash flows

profit maximization

measuring wealth