Mini Case:
Introduction to
the
Foundations of
Financial
Management.
By: Rayne Everage
Mini Case
The final stage in the interview process for an
assistant financial analyst at Caledonia
Products involves a test of your understanding
of basic financial concepts. You are given the
following memorandum and asked to respond
to the questions. Whether you are offered a
position at Caledonia will depend on the
accuracy of your response.
To: Applicants for the position of Financial Analyst
From: Mr. V. Morrison, CEO, Caledonia Products
Re: A test of your understanding of basic financial
concepts and of the corporate tax code.
Overview
 Goal
of a Firm
 Risk-Return-Trade-Off
 Importance of Cash Flows
 Efficient Market Hypothesis
 Agency Problem
 Ethics & Finance
 Sole Proprietorship
 Partnership
 Corporation
 Questions
Goal of a Firm
 Capitalist
Society: there is private
ownership of goods and services by
individuals.

Those individuals own the means of production
to make money. The profits from the businesses
in the economy accrue to the individuals.
 The
fundamental goal of a business is to
create value for the company’s owners.
Goal of a Firm

Also known as “maximizing shareholder wealth”.
 The effects of all the financial decisions
ultimately affect the firm’s stock price.
 As the stock price increases, the individual who
holds the stock wealth increases. As the stock
price goes up, the value of the firm increases
and the net worth of the individual who owns
the stock increases.

To employ this goal, we do not need to consider
every change in stock price. What we do need to
focus on is the effect that a decision should have
on the stock price if everything else were held
constant.
Goal of a Firm

Agency Problem
 Conflict between the managers of a firm and
the Board of Directors.
 Important to resolve this quickly as it can
impede on performance.

Social Responsibility
 Need to be socially responsible to exist and
profit in the long run.
Risk-Return-Trade-Off

Defined as: The principal that return arises with an
increase in risk. Low levels of uncertainty render low
potential returns, whereas high levels or uncertainly
render high potential returns.
*Source: www.investopedia.com
Risk-Return-Trade-Off

Investors will not invest unless they know they will
receive a return on their investment.

A return for delaying consumption: the money an
investor may provide, could be invested
elsewhere, therefore investors expect a return
(opportunity cost).
Importance of Cash Flows

“Revenue is vanity, Cash Flow is sanity, but Cash is
king”

Cash flows are necessary for the firm to survive and
prosper.

Cash flows represent money that can be spent,
and determines the value of a business.
 Focus on this, not profits.

Incremental cash flow: the difference between the
cash flows a company will produce both with and
without the investment it is thinking about making.
Efficient Markets Hypothesis

http://www.investopedia.com/video/play/efficien
t-market-hypothesis/
Agency Problem

“A conflict of interest inherent in any relationship
where one party is expected to act in another's
best interests. The problem is that the agent who is
supposed to make the decisions that would best
serve the principal is naturally motivated by selfinterest, and the agent's own best interests may
differ from the principal's best interests. The
agency problem is also known as the "principal–
agent problem”
(www.investopedia.com/terms/a/agencyproblem.asp).
Agency Problem & Solution

Most commonly found between the board or
directors and the management. The
management acts as the shareholders agent to
maximize their wealth, however management’s
best interest is to maximize individual wealth.

It is not possible to eliminate the problem
completely, however management can be
motivated, by incentives, direct influence of
shareholders, threat of termination or takeovers.
Ethics & Finance

Ethical issues in finance affect everyone, even if
you don’t work in the field you are a consumer of
its services.

It appears the financial industry is full of scandals
and is possibly the most unethical field.

Greed is a powerful emotion. If pursuing a career
in the financial field it is crucial that one
understands the basics and principals of finance
to understand how to deal with particular
situations
Ethics & Finance

Material Non-Public Information
 EX. CEO explains in meeting that upcoming
earnings will be disappointing. You own stock in
the company. It is important you do not inform
your broker and sell the stock, this is considered
insider trading.

The High Road
 You may not be involved in an unethical
situation, however, if you knowingly allow it to
continue, you could be held accountable also.
Sole Proprietorship

Not a legal entity

One person owns the business and is personally
responsible for its debts

Popular business form due to ease of set up and
nominal cost.

Register name and secure local licenses

Many business begin as Sole Proprietorship and
then evolve into more complex business form as
business develops.
Sole Proprietorship
Advantages
Disadvantages
Establish instantly, easily and
inexpensively
Unlimited personal liabilities for
debts, losses and liabilities of
the business
Carry little, if any ongoing
formalities
Cannot raise capital by selling
and interest in the business
Does not need to pay
unemployment tax on
him/herself
Rarely survive the death or
incapacity of their owners, so
do not retain value
May freely mix business and
personal assets
Partnership

“A legal form of business operation between two or
more individuals who share management and profits.
The federal government recognizes several types of
partnerships. The two most common are general and
limited partnerships” (www.entrepreneur.com)
General
Limited
Partners manage
company and assume
responsibility for the
partnership’s debts and
other obligations.
Has general and limited
partners. General partners
own and operate the
business and assume
liability for the partnership.
Limited partners serves as
investors, who have no
control over the company
and are not subject to
same liabilities.
Partnership

Major advantage of a partnership is the tax
treatment. It does not pay tax on its income but
“passes through” any profits or losses to the
individual partners.

Still high amount of personal liability, and it only
takes one partner to make financial decisions
which could effect all partners involved.

Expensive to establish due to legal and
accounting services.
Corporation

“A legal entity that is separate and distinct from its
owners. Corporations enjoy most of the rights and
responsibilities that an individual possesses; that is,
a corporation has the right to enter into contracts,
loan and borrow money, sue and be sued, hire
employees, own assets and pay taxes”
(www.investopedia.com)

Created by large group of shareholders who have
ownership based on their holding of common
stock
Corporation

Shareholders elect a board of directors who
oversee management.

Corporations do not have to be for profit, majority
of them have a goal of maximizing shareholder
wealth.
Questions?
 Thank
you!!