intro to foundation of finance

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

Foundations of FinanceArthur J. Keown John D. MartinJ. William Petty David F. Scott, Jr.

Chapter 1

An Introduction to the Foundations of Financial Management – The Ties

that Bind

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Chapter Objectives

• Identify the goal of the firm.

• 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.

• Describe the corporate tax features that affect business decisions.

• Describe the corporate tax features that affect decisions.

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

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

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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

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Profit Maximization

• Stresses the efficient use of capital resources

• Not specific to time frame for profits to be measured

• Goals are not precise, allow for misinterpretation

• Ignores uncertainty and timing

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Benefits of Maximizing Shareholder Wealth

• Good decisions are those that create wealth for the shareholder

• Societal benefits as businesses compete to create wealth

• Includes effects of all financial decisions

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Legal Forms of Business Organization

• Sole Proprietorship

• Partnership

• Corporation

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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 owner’s choice

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Partnerships

• General Partnership– Each partner is fully responsible

for liabilities

• Limited Partnerships

• Two or more owners

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Partnerships

• Limited Partnership and Limited Liability Company– Allows one or more partners limited

liability based on amount of capital invested

– Must have one general partner with unlimited liability

– Names of limited partners may not appear in name of firm

– Limited partners may not participate in management decisions.

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Corporation

• Legally functions separate and apart from its owners– Can sue, be sued, purchase, sell, and own

property• Owners who dictate direction and policies

– Elect a board of directors• Investors liability is restricted to amount of

investment in company• Life continues with transfer of ownership• Taxed separately

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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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Comparison of Organizational Forms

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

• Limited Partnership– Limited liability for partners– Practical number of partners restricted– Restricted marketability of interest in

partnership

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Organizational Form and Taxes

• Corporation– Double taxation of dividends– Tax act of 2003 limited tax rate on

dividends to stimulate the economy• Ends in 2008 unless Congress takes

action

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Organizational Form and Taxes

• S-Type Corporations– Benefits

• Limited liability• Taxed as partnership

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

between two corporations

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Organizational Form and Taxes

• Limited Liability Corporations– Benefits

• Limited liability• Taxed like a partnership

– Limitations• Qualifications vary from state to state• Can’t appear like corporation

otherwise will be taxed like one

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The Role of the Financial Manager in a Corporation

HOW THE FINANCE AREA FITS INTO A CORPORATION

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Objectives of Income Taxation

• Raise revenues for government expenditures

• Achieve socially desirable goals

• Economic stabilization

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Types of Taxpayers

• Individuals– employees, self-employed persons, members of

partnerships– Report income on personal tax return

• Corporations– separate legal entity– Report income on corporate tax return– Distributed dividends taxed to shareholders

• Fiduciaries– estates and trusts– Pay taxes on undistributed income

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Computing Taxable Income

• 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

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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

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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

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Marginal Tax Rates

• Rates applicable to next dollar of income

• Used in financial decision-making

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Other Corporate Tax Considerations

• Dividend Exclusion– A corporation may typically exclude 70% of any

dividend received from another corporation.

• Depreciation Expense– A corporation may expense an asset’s cost over

its useful life

• Capital Gains and Losses– Capital Gains taxed as ordinary income. Capital

losses cannot be deducted from ordinary income.

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

Ten Principles That Form 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.”

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

1. The Risk-Return Trade-off2. The Time Value of Money3. Cash—Not Profits—Is King4. Incremental Cash Flows5. The Curse of Competitive Markets6. Efficient Capital Markets7. The Agency Problem8. Taxes Bias Business Decisions9. All Risk is Not Equal10. Ethical Behavior Is Doing the Right Thing,

and Ethical Dilemmas Are Everywhere in Finance

10 Principles of Financial Management

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Principle 1: 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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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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Principle 3: 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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Principle 4: Incremental Cash Flows

• It is only what changes that counts

• 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.

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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, Service and

Quality can insulate products from competition

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Principle 6: 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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Principle 7: 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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Principle 8: Taxes Bias Business Decisions

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

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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.

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

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

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Finance and the Multinational Firm

• U.S. corporations are looking to international expansion– Collapse of communism– Acceptance of free market system

developing in the Third World countries

– PC’s and the internet– Freer access to international

markets