Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Foundations of Finance
Arthur J. Keown John D. Martin
J. William Petty

Chapter 1
An Introduction to the Foundations
of Financial Management
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

The Goal of the Firm

• The goal of the firm is maximization

of shareholder wealth
or
• Maximization of the price of the
existing common stock

• Good decisions are those that create

wealth for the shareholder
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Five Principles That Form The

Foundations of Finance

“…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.”
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Principle 1: Cash—Not Profits

—Is King

• Cash Flow, not accounting

profit, is used as our
measurement tool.

• Cash flows, not profits, are

actually received by the firm
and can be reinvested.
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Principle 2: The Time Value

of Money

• A dollar received today is worth

more than a dollar received in the
future.

• Because we can earn interest on

money received today, it is better to
receive money earlier rather than
later.

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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Principle 3: The Risk-Return

Trade-off

• We won’t take on additional risk

unless we expect to be
compensated with additional return.
• Investment alternatives have
different amounts of risk and
expected returns.
• The more risk an investment has, the
higher its expected return will be.

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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Principle 4: Efficient Capital

Markets

• The markets are quick and the

prices are right.

• The values of all assets and

securities at any instant in time
fully reflect all available
information.

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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Principle 5: The Agency

Problem

• Managers won’t work for the owners

unless it is in their best interest

• 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.
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 Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

The role of Finance in Business

• Capital budgeting
– What long-term investments or projects
should the business take on?
• Capital structure
– How should we pay for our assets?
– Should we use debt or equity?
• Working capital management
– How do we manage the day-to-day
finances of the firm?

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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

The Capital Budgeting Decision

Total Value of Assets:
Total Firm
Value to Current
Investors : Liabilities
Current
Assets Long-
Term
Debt
What long-
Fixed Assets
term
1 Tangible investments
2 Intangible should the
Sharehol
firm engage ders’
in? Equity
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

The Capital Structure Decision

Total Firm Value to
Total Value of Assets :
Investors: Current
Liabilitie
s
Current Long-
Assets Term
How can the firm
Debt
raise the money
Fixed Assets for the required
1 Tangible investments?
2 Intangible Sharehol
ders’
Equity
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

The Role of the Financial

Manager in a Corporation
HOW THE FINANCE AREA FITS INTO A CORPORATION

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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Legal Forms of Business

Organization

Three major forms in the United States

• Sole Proprietorship

• Partnership

• Corporation

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 Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Sole Proprietorship

• Advantages • Disadvantages
– Easiest to start – Limited to life of
– Least regulated owner
– Single owner – Equity capital
keeps all of the limited to owner’s
profits personal wealth
– Taxed once as – Unlimited liability
personal income – Difficult to sell
ownership interest

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 Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Partnership

• Advantages • Disadvantages
– Two or more – Unlimited liability
owners • General partnership
– More capital • Limited partnership
available – Partnership
– Relatively easy to dissolves when one
start partner dies or
wishes to sell
– Income taxed once
as personal income – Difficult to transfer
ownership

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 Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Corporation

• Advantages • Disadvantages
– Limited liability – Separation of
ownership and
– Unlimited life management (agency
– Separation of problem)
ownership and – Double taxation
management (income taxed at the
– Transfer of corporate rate and
ownership is easy then dividends taxed
at personal rate,
– Easier to raise while dividends paid
capital are not tax
deductible)
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Taxation of Business Income

Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Comparison of Organizational
Forms

• Large growing firms choose the

corporate form
– Ease in raising capital

– Limited liability

– Transfer of ownership is simple

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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Computing Taxable Income ($000’s)

Sales $50,000
Cost of Goods Sold 23,000
Gross Profit $27,000
Operating Expenses
Administrative Expenses $4,000
Depreciation Expense 1,500
Marketing Expenses 4,500
Total Operating Expenses $10,000
Operating Income $17,000
Other Income 0
Interest Expense 1,000
Taxable Income $16,000

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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Multiple Choice
Questions
 Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Question 1
•  A sole proprietorship is defined as
a business: 
a. engaged in a single operation.
b. that produces only one product.
c. that employs a single employee.
d. owned by a single individual.
e. that is unincorporated.

• D. owned by a single individual.

 Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Question 2
A business organization owned by two
or more individuals or entities, each
of whom has unlimited liability for
the firm's debts, is called a: 
a. limited liability company.
b. limited partnership.
c. dual company.
d. joint stock company.
e. general partnership
E. general partnership
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Question 3

The potential conflict of interest

between a firm's owners and its
managers is referred to as a(n): 
a. organizational problem.
b. structure problem.
c. agency problem.
d. control issue.
e. management conflict
C. agency problem.
Question 4
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

When analyzing alternative capital

structures for a firm, a financial
manager must consider which of the
following?

I. type of loan
II. amount of funds needed
III. cost of funds
IV. mix of debt and equity
 
a. II and IV only
b. I and III only
c. II, III, and IV only
d. I, III, and IV only
e. I, II, III, and IV
E. I, II, III, and IV
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Question 5

The capital structure of a firm

refers to the firm's: 
a. buildings and equipment.
b. combination of assets.
c. available cash.
d. long-term debt and equity.
e. current assets and liabilities
D. long-term debt and equity.
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Question 6

A sole proprietorship: 
a. is relatively easy to create.
b. involves significant legal costs
during the formation process.
c. has an unlimited life.
d. is taxed as a separate legal entity.
e. can generally raise significant
capital from non-owner sources.
A. is relatively easy to create.
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Question 7

The advantage of being a limited partner in a

limited partnership is the ability to: 
a. earn a profit without risking your investment
in the firm.

b. actively manage the firm without losing more

than you invested.
c. control the daily operations of the firm while
limiting your losses to your initial investment.
d. avoid taxes on your partnership earnings.
e. limit your losses to the amount invested in
the firm.
E. limit your losses to the amount invested in the
firm.
 Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Question 8
Which one of the following statements about a
limited partnership is correct?
 
a. All partners have limited liability for partnership
debts.

b. The partnership is managed on a daily basis by its

limited partners.

c. Each limited partnership must have at least one

general partner.

d. Partnership profits are taxed the same as

corporate profits.

e. The partnership has an unlimited life

C. Each limited partnership must have at least one

general partner.
 Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Question 9
Which of the following are advantages of
the
corporate form of organization?

I. ability to raise large sums of capital

II. ease of ownership transfer
III. corporate taxation
IV. unlimited firm life
 
a. I and II only
b. III and IV only
c. II, III, and IV only
d. I, II, and IV only
e. I, II, III, and IV
D. I, II, and IV only
 Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Question 10
 Limited liability companies are primarily
designed to:

I. be taxed like a partnership.

II. be taxed like a corporation.
III. operate like a corporation.
IV. provide limited liability for the
owners.
 
a. I and IV only
b. II and IV only
c. I and III only
d. II and III only
e. IV only
A. I and IV only
 Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND

Question11
The primary goal of financial
management is to maximize the: 
a. current net income.
b. net working capital.
c. the number of shares
outstanding.
d. market value of the existing
stock.
e. revenue growth.
D. market value of the existing stock.