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
Financial
Management : An
Overview
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
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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Definition of Financial Mgt.
• Financial Management- is the
process of transforming existing
assets into new, contractual
forms, as well as the analytical
techniques needed to support
this process, for the purpose of
wealth creation in modern,
capitalistic economies.
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Another Definition:
Financial Management entails
planning for the future for a
person or a business enterprise
to ensure a positive cash flow. It
includes the administration and
maintenance of financial assets.
Besides, financial management
covers the process of identifying
and managing risk.
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Scope of Financial
Management
• Money and Capital Markets which deals with securities
markets and financial
institutions;
• Investments -which focuses on
the decisions.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Cont.,
• made by both individual and
institutional investors as they
choose securities for their
investment portfolios.
• Financial Management-or
‘business finance’, which
involves decisions within firms.
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Financial Mgt. Decisions
• Capital Budgeting: The process
of planning and managing a
firm’s long term investment.
• Capital Structure: The mixture
of debt and equity maintained
by the firm.
• Working Capital Management
short terms asset and
liabilities.
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Foundations of Finance
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Capital Budgeting
• Capital Budgeting(or investment
appraisal)- is the planning process used to
determine whether a firm's long term
investments such as new machinery,
replacement machinery, new plants, new
products, and research development
projects are worth pursuing. It is budget
for major capital, or investment,
expenditures.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Capital Budgeting Techniques
• Net Present Value (NPV) -each
potential project's value is
estimated using a
discounted cash flow (DCF)
valuation, to find its NPV.
• Profitability Index (PI) -identifies the
relationship of investment to payoff
of a proposed project.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Cont.,
• Profitability index (PI) -identifies the
relationship of investment to payoff
of a proposed project.
• Internal rate of return (IRR) -defined
as the discount rate that gives a net
present value of zero. It is a
commonly used measure of
investment efficiency
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Importance of Working
Capital Management
1. Cash Management- Identify the
cash balance which allows for
the business to meet day to day
expenses, but reduces cash
holding costs.
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Cont.,
2. Inventory Management- Identify
the level of inventory which
allows for uninterrupted
production but reduces the
investment in raw materials -and
minimizes reordering costs - and
hence increases cash flow;
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Cont.,
3. Debtors Management. Identify
the appropriate credit policy,
i.e. credit terms which will
attract customers, such that
any impact on cash flows and
the Cash conversion cycle will
be offset by increased revenue
and hence Return on Capital (or
vice versa).
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Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Cont.,
4. Short Term Financing- Identify the
appropriate source of financing,
given the cash conversion cycle: the
inventory is ideally financed by
credit granted by the supplier;
however, it may be necessary to
utilize a bank loan (or overdraft), or
to "convert debtors to “ cash"
through "factoring".
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Foundations of Finance
Pearson Prentice Hall
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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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Objectives of Income Taxation
• Raise revenues for government
expenditures
• Achieve socially desirable goals
• Economic stabilization
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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Foundations of Finance
$50,000
23,000
$27,000
$4,000
1,500
4,500
$10,000
$17,000
0
1,000
$16,000
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Corporate Tax Rates
Income
$ 0 - $50,000
$50,001 - $75,000
$75,001 - $10,000,000
Over $10,000,000
Rate
15%
25%
34%
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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Foundations of Finance
Pearson Prentice Hall
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
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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Foundations of Finance
Pearson Prentice Hall
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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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Foundations of Finance
Pearson Prentice Hall
Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Foundations of Finance
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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
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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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Finance and the Multinational
Firm
• Some Corporations are looking
For 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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Chapter 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT – THE TIES THAT BIND
Next chapter…………..
•
End of the Chapter
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Foundations of Finance
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