Module 1 General Overview of Financial Management

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Chapter 1 AN INTRODUCTION TO FI NANCIAL MANAGEMENTTHE 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 thefirm.

Compare the various legalforms of business

organization and explainwhy the corporate form ofbusiness is the most logicalchoice for a firm that islarge or growing.

Describe the corporate taxfeatures that affect

business decisions.

Describe the corporate taxfeatures that affectdecisions.

Explain the 10 principlesthat form the foundationsof financial management.

Explain what has led to theera of the multinationalcorporation.


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The Goal of the Firm

The goal of the firm is maximization ofshareholder wealth

or

Maximization of the price of the existingcommon stock


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Profit Maximization

Stresses the efficient use of capitalresources

Not specific to time frame for profits to bemeasured

Goals are not precise, allow formisinterpretation

Ignores uncertainty and timing


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Benefits of MaximizingShareholder Wealth

Good decisions are those that createwealth for the shareholder

Societal benefits as businesses compete tocreate wealth

Includes effects of all financial decisions


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Legal Forms of BusinessOrganization

Sole Proprietorship

Partnership

Corporation


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Sole Proprietorship

Business owned by an individual

Owner maintains title to assets andprofits

Unlimited liability

Termination occurs on owners deathor by owners 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 ownproperty

Owners who dictate direction and policies

Elect a board of directors

Investors liability is restricted to amount of investmentin company

Life continues with transfer of ownership Taxed separately


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Comparison of OrganizationalForms

Large growing firms choose thecorporate form

Ease in raising capital

Limited liability

Transfer of ownership is simple


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Comparison of OrganizationalForms

Sole Proprietorship and GeneralPartnership

Unlimited liabilities Not as easy to raise capital

Limited Partnership

Limited liability for partners Practical number of partners restricted

Restricted marketability of interest inpartnership


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Organizational Form and Taxes

Corporation

Double taxation of dividends

Tax act of 2003 limited tax rate ondividends to stimulate the economy

Ends in 2008 unless Congress takes action


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S-Type Corporations

Benefits

Limited liability

Taxed as partnership

Limitations

Owners must be people Cant be used for joint ventures between

two corporations


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Limited Liability Corporations

Benefits

Limited liability

Taxed like a partnership

Limitations

Qualifications vary from state to state Cant appear like corporation otherwise

will be taxed like one

C 1 O C O O C G S


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The Role of the FinancialManager in a Corporation

HOW THE FINANCE AREA FITS INTO A CORPORATION


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Ten Principles That Form The

Foundations of FinancialManagement

although it is not necessary to

understand finance in order to understand

these principles, it is necessary tounderstand these principles in order to

understand finance.

Ch t 1 AN INTRODUCTION TO FI NANCIAL MANAGEMENT THE TIES THAT BIND


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Principle 1: The Risk-ReturnTrade-off

We wont take on additional risk unless weexpect to be compensated with additional

return.

Investment alternatives have differentamounts of risk and expected returns.

The more risk an investment has, thehigher its expected return will be.

Ch t 1 AN INTRODUCTION TO FI NANCIAL MANAGEMENT THE TIES THAT BIND


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Principle 2: The Time Value ofMoney

A dollar received today is worth more thana dollar received in the future.

Because we can earn interest on moneyreceived today, it is better to receivemoney earlier rather than later.

Chapter 1 AN INTRODUCTION TO FI NANCIAL MANAGEMENT THE TIES THAT BIND


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Principle 3: CashNotProfitsIs King

Cash Flow, not accounting profit, isused as our measurement tool.

Cash flows, not profits, are actuallyreceived by the firm and can be

reinvested.



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Principle 4: Incremental CashFlows

It is only what changes that counts

The incremental cash flow is thedifference between the projected cashflows if the project is selected, versus

what they will be, if the project is notselected.



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Principle 5: The Curse ofCompetitive Markets

It is hard to find exceptionally profitable projects

If an industry is generating large profits, new

entrants are usually attracted. The additionalcompetition and added capacity can result in profitsbeing driven down to the required rate of return.

Product Differentiation, Service and Qualitycan insulate products from competition



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Principle 6: Efficient CapitalMarkets

The markets are quick and theprices are right.

The values of all assets andsecurities at any instant in time fully

reflect all available information.



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Principle 7: The AgencyProblem

Managers wont work for the ownersunless it is in their best interest

The separation of management andthe ownership of the firm creates anagency problem. Managers may make decisions that are

not in line with the goal ofmaximization of shareholder wealth.



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Principle 8: Taxes BiasBusiness Decisions

The cash flows we consider are

the after-tax incremental cashflows to the firm as a whole.



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Principle 9: All Risk is NotEqual

Some risk can be diversified away,

and some cannot The process of diversification can

reduce risk, and as a result,measuring a projects or an assetsrisk is very difficult.



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Principle 10: Ethical Behavior Is Doingthe Right Thing, and Ethical Dilemmas

Are Everywhere in Finance

Each person has his or her own set of

values, which forms the basis forpersonal judgments about what isthe right thing



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Finance and the Multinational Firm

U.S. corporations are looking tointernational expansion

Collapse of communism Acceptance of free market system

developing in the Third World countries

PCs and the internet

Freer access to international markets

Documents

Module 1 General Overview of Financial Management