Foundations of Finance
Arthur Keown
John D. Martin
J. William Petty
An Introduction to the Foundations of
Financial Management
– The Ties that Bind
Chapter 1
Learning Objectives
1.
2.
3.
4.
5.
6.
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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3
Slide Contents
1.
2.
3.
4.
5.
6.
The Goal of the Firm
Legal Forms of Business Organization
Role of Financial Manager in a
Corporation
Income Taxation
Ten Principles of Finance
Finance and Multinational Firm
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1. The Goal of the Firm
The Goal of the Firm


The goal of the firm is to maximize
shareholder wealth.
Shareholder wealth is measured by share
prices. Thus shareholder wealth maximization
would imply maximizing the price of common
stock.
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6
Part of Coca-Cola’s Vision

“Maximizing return to shareowners while
being mindful of our overall
responsibilities.”
— http://www.thecoca-colacompany.com/ourcompany/mission_vision_values.html
(retrieved March 13, 2007)
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Benefits of Maximizing
Shareholder Wealth


Good corporate decisions are those that
create wealth for the shareholder.
Society benefits as scarce resources are
directed to the most profitable use by
businesses competing to create wealth.
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Share Price Changes (during last
two years as of June 29, 2007)


Google: Share price increased by nearly $200
or around 67% (from around $300 to $500)
… wealth created.
Yahoo: Share price decreased by nearly $8 or
around 23% (from around $35 to $27) …
wealth destroyed.
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Why is Profit Maximization not
the appropriate goal?



Profit maximization goal is unclear about the
time frame over which profits are to be
measured.
It is easy to manipulate the profits through
various accounting policies.
Profit maximization goal ignores risk and timing
of cash flows.
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2. Legal Forms of Business
Organization
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


Partnership: Two or more persons come
together as co-owners.
Two types of partnership: General or Limited
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Partnership - General

All partners are fully responsible for
liabilities incurred by the partnership.
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Partnerships - Limited



One or more partners can have limited
liability
There must be at least one general partner
with unlimited liability.
Limited partners cannot participate in the
management of the business and their names
cannot appear in the name of the firm.
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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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Corporation




Legally functions separate and apart from its
owners
 Corporation can sue, be sued, purchase, sell,
and own property
Owners (shareholders) dictate direction and
policies of the corporation.
Shareholder’s liability is restricted to the
amount of investment in company.
Life of corporation does not depend on the
status of its owners. Ownership can be easily
transferred.
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The Trade-offs:
Corporate Form

Benefits:




Limited liability
Easy to transfer ownership
Unlimited life (unless the firm goes through corporate
restructuring such as mergers and bankruptcies)
Drawbacks:




No secrecy of information
Maybe delays in decision making
Greater regulation
Double taxation
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Double Taxation example


Income
Federal Tax @25%
After tax Income
= $1,000
= $250
= $750
What will be the total tax if the
company chooses to distribute the
after-tax profits to shareholders as
dividends?
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Double taxation



If corporation distributes the profits as
dividends to shareholders, shareholders will
have to pay taxes on dividends.
Assume shareholders are taxed @20% on
dividend income or 20% of $750 = $150
Total tax = 250 + 150 = $400 or 40%
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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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3. Role of Financial Manager in a
Corporation
The Role of the Financial Manager in
a Corporation (figure 1.1)
HOW THE FINANCE AREA FITS INTO A CORPORATION
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The Role of the Financial Manager in
a Corporation (figure 1.1)

In this textbook, we focus on the duties
generally associated with the treasurer
and how investment decisions are
made.
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4. Income Taxation
Income Taxation

Objectives:

Raise revenues for government
expenditures

Achieve socially desirable goals

Economic stabilization
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Types of Taxpayers

Individual



Corporation



Includes employees, self-employed persons,
members of partnerships
Reports income on personal tax return
Reports its income and pays tax on profits
Distributed dividends taxed to shareholders
Fiduciaries

Such as estates and trusts pay taxes on income
generated by the estate or trust that is not
distributed to a beneficiary
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Computing Taxable Income
for Corporation

Taxable Income


Gross Income


Gross income less tax deductible expenses, plus interest
income and dividend 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
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
$50,000
23,000
$27,000
$4,000
1,500
4,500
$10,000
$17,000
0
1,000
$16,000
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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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Example: Computing taxes on
taxable income of $16m
$50,000
$25,000
$9,925,000
$6,000,000
Surtax
*
*
*
*
.15
.25
.34
.35
.05*($335K-$100K)
.03*($16m - $15m)
Total Tax
=
=
=
=
7,500
6,250
3,374,500
2,100,000
= 11,750
= 30,000
= $5,530,000
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Marginal Tax Rates

Refers to the tax rate applicable to next dollar
of income.


In the previous example, the marginal tax rate is
38% since $16m falls into the 35% tax bracket
with a 3% surtax.
In financial decision-making, marginal tax
rate is more relevant than average tax rate.
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Other Corporate Tax
Considerations

Dividend Exclusion


Depreciation Expense


A corporation may typically exclude 70% of any dividend
received from another corporation.
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.
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5. Ten Principles:
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


Would you invest your savings in the
stock market if it offered the same
expected return as your bank?
We won’t take on additional risk unless
we expect to be compensated with
additional return.

Higher the risk of an investment, higher
will be its expected return.
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The Risk-Return Trade-off
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Principle 2:
The Time Value of Money

A dollar received today is worth more than a
dollar to be 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

In measuring wealth or value, we use cash
Flow, not accounting profit, as our
measurement tool.


Cash flows are actually received by the firm and
can be reinvested. On the other hand, profits are
recorded when they are earned rather than when
money is actually received.
It is possible for a firm to show profits on the
books but have no cash!
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Principle 4:
Incremental Cash Flows

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.

This difference reflects the true impact of a
decision.
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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 (through Service, Quality)
and cost advantages (through economies of Scale)
can insulate products from competition.
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Principle 6:
Efficient Capital Markets



The values of securities at any instant in time
fully reflect all publicly available information.
Prices reflect value and are right.
Price changes reflect changes in expected
cash flows (and not cosmetic changes such
as accounting policy changes). Good
decisions drive up the stock prices and vice
versa.
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Principle 7:
The Agency Problem

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.
Agency conflict reduced through monitoring (ex.
Annual reports), compensation schemes (ex. stock
options), and market mechanisms (ex. Takeovers).
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Principle 8:
Taxes Bias Business Decisions

The cash flows we consider for
decision making 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. A project’s risk changes depending
on whether you measure it standing alone or
together with other projects the company may
take on.
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All Risk is Not Equal
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Principle 10:
Ethical Behavior Is Doing the Right Thing, and Ethical
Dilemmas Are Everywhere in Finance


Ethical dilemma — Each person has his or her
own set of values, which forms the basis for
personal judgments about what is the right
thing.
Ethics are relevant in business and unethical
decisions can destroy shareholder wealth (ex.
Enron Scandal).
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6. Finance and Multinational Firm
Finance and the Multinational Firm

U.S. corporations are looking to international expansion to
discover profits



For example, Coca-Cola earns over 80% of its profits from overseas
sales
In addition to US firms going abroad, we have also witnessed
many foreign firms making their mark in the United States (ex.
the domination of the auto industry by Honda, Toyota, and
Nissan)
International movement has been spurred by:




Collapse of communism
Acceptance of free market system developing in Third World
countries
Technology and communication (PC’s and the internet)
Improved transportation
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Why do companies go abroad?




To increase revenues
To obtain cheaper resources (land, labor,
capital, raw material)
To reduce the burden of government
regulation (ex. Environmental laws, taxes,
labor laws)
To increase global exposure
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Risks/challenges



Country risk (changes in government
regulations, unstable government, economic
changes)
Currency risk (fluctuations in exchange rates)
Cultural risk (differences in language,
traditions, ethical standards etc.)
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