Chapter 1

An Introduction
to the Foundations
of Financial
Management
 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
98,21 D
• 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. to'd I I
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• Good financial decisions will increase stock
price and poor financial decisions will lead to
a decline in stock price. finance
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 I

FIVE PRINCIPLES
THAT FORM THE FOUNDATIONS
OF FINANCE

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 Principle 1:
i Cash Flow Is What Matters
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• 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. Hd 3 521 a 29,5 p't job big big
• We must determine incremental or marginal cash
flows when making financial decisions. t 83kg7
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- Incremental cash flow is the difference between
projected cash flows if the project is selected, versus what

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they will be, if the project is not selected.

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 Principle 2: saw
Build
Money Has a Time Value Ji sa

• 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. ie ti m ji wi i LD
P N I I w ji o Was Wil I do
– 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: implies
Risk Requires a Reward risk To
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• 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 531k
• In an efficient market, the market prices of all
w
MI and bonds)
traded assets (such as stocks fully
reflect all available information at any instant in
time. stock owner
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bonds crideter
• Thus stock prices are a useful indicator of the value
of the firm. Price changes reflect changes in
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expected future cash flows. Good decisions will tend
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to increase in stock price and vice versa.

• Note there are inefficiencies in the market that may

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distort the market prices from value of assets. Such
inefficiencies are often caused by behavioral biases.
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info
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 Principle 5: Conflicts of Interest
Cause Agency Problems II
4591
• 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.
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– Agency conflict is reduced through monitoring EE
it (ex. annual reports), compensation schemes
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(ex. takeovers)
14,5911 managers
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 Discussion: The Global Jim
Financial Crisis Mein
Iww
• What factors contributed to the global
financial crisis? Pij
• What do we mean by subprime loans? Isl
• How are mortgages securitized? ftp
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• How have unemployment rates fared? Jl .gwlwJ
Jet

• How can the financial crisis be explained

using the five principles of finance?
ismail 12 x'T

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 Ethics & Trust in Business
11Mt capital but jet 7
I
• 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 Jw 415 N

Three basic issues addressed by the study of

finance: Tocreatevalue on
buisness
the
• What long-term investments should the firm
I undertake? (Capital budgeting decision)manageanddeside
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• How should the firm raise money to fund theseId is a
2
investments? (Capital structure decision) II Da 1,5
from
stony e Assetcutlibility
3 • 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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 WE JI

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 THE LEGAL FORMS
OF BUSINESS ORGANIZATION

58,2108
I am

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 The Legal Forms of
Business Organization
58 10851
Business Forms

Sole
Partnership Corporation Hybrid Is
Proprietorship

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Jew so
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S-Type LLC

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limit LibilityCompany
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 Sole Proprietorship
business
• Business owned by an individual
• Owner maintains title to assets and profits
• Unlimited liability
• Termination occurs on owner’s death or by
f
the owner’s choice

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 Partnership
E business
• Two or more persons come together as co-owners
• General Partnership: All partners are fully
responsible for liabilities incurred by the
0631
partnership.
Days W
• Limited Partnerships: One or more partners can
have limited liability, restricted to the amount of
capital invested in the partnership. There must be
É at least one general partner with unlimited liability.
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88 Limited partners cannot participate in the
09 II
3 management of the business and their names 66381
cannot appear in the name of the firm. 019261
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 Corporation
del 58,5
• 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. Ju Wise tow
• Shareholder’s liability is restricted to amount of
investment in company. DIII wat w w Im
• Life of corporation does not depend on the owners …
corporation continues to be run by managers after
transfer of ownership through sale or inheritance.
I 361st III I

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 swigs D
The Trade-offs:
FypeCorporate Form EX 9
owner
business
manager
lg
• 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).

I
• Drawbacks: No secrecy of information,
maybe delays in decision making, greater
regulation, double taxation.
Ctype
s type
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 Double Taxation Example
e
Type
• Assume earnings before tax = $1,000
Federal Tax @ 25% = $250
OWEI
After tax income available for distribution to
shareholders = $750
WH t

• 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:
as S-Corporation and Limited Liability 3,656
I E e
Companies (LLCs)
Est Es 1
Is
• S-Type Corporations I 6
missy
– 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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tibia II Es
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 Hybrid Organizations:
S-Corporation and Limited Liability
Companies (LLCs) (cont.)

• Limited Liability Companies (LLC)

– Benefits
• Limited liability
• Taxed like a partnership Is
– Limitations
• Qualifications vary from state to state
• Cannot appear like a corporation otherwise it will be
taxed like one

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 1

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 FINANCE AND THE
MULTINATIONAL FIRM:
THE NEW ROLE
5 I I

Ibid

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 Finance and The Multinational
Firm: The New Role
honda Toyota
nessay
• 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.

I Hos III A

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 Review: Key Terms

• Agency problem • Incremental cash flow

• Capital budgeting • Limited partnership
• Capital structure • Limited Liability
decisions Company (LLC)
• Corporation • Partnership
• Efficient market • Opportunity cost
• Financial markets • Sole proprietorship
• General partnership • S-corporation
• Working capital
management

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