Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT

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

Foundations of Finance

Arthur J. Keown John D. Martin

J. William Petty David F. Scott, Jr.

Chapter 1

An Introduction to the Foundations of Financial Management – The Ties that Bind


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.

1 - 2 Foundations of Finance Pearson Prentice Hall


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

Foundations of Finance 1 - 3 Pearson Prentice Hall


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



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



Legal Forms of Business

Organization

• Sole Proprietorship

• Partnership

• Corporation



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

• Two or more owners

• General Partnership

– Each partner is fully responsible for liabilities

• Limited Partnerships



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.



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



Comparison of Organizational

Forms

• Large growing firms choose the corporate form

– Ease in raising capital

– Limited liability

– Transfer of ownership is simple



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



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




• S-Type Corporations

– Benefits

• Limited liability

• Taxed as partnership

– Limitations

• Owners must be people

• Can ’ t be used for joint ventures between two corporations




• 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



The Role of the Financial

Manager in a Corporation

HOW THE FINANCE AREA FITS INTO A CORPORATION



Objectives of Income Taxation

• Raise revenues for government expenditures

• Achieve socially desirable goals

• Economic stabilization



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



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



Computing Taxable Income ($000 ’ s)

Sales

Cost of Goods Sold

Gross Profit

Operating Expenses

Administrative Expenses

Depreciation Expense

Marketing Expenses

Total Operating Expenses

Operating Income

Other Income

Interest Expense

Taxable Income

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$4,000

1,500

4,500

$50,000

23,000

$27,000

$10,000

$17,000

0

1,000

$16,000

Pearson Prentice Hall


Corporate Tax Rates

Income

$ 0 - $50,000

$50,001 - $75,000

$75,001 - $10,000,000

Over $10,000,000

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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Rate

15%

25%

34%

35%

Pearson Prentice Hall


Marginal Tax Rates

• Rates applicable to next dollar of income

• Used in financial decision-making



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.



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.”


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.



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.



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.



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.



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



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.



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.



Principle 8: Taxes Bias

Business Decisions

• The cash flows we consider 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.



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



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


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