Financial Management: Principles & Applications Fourteenth Global Edition Chapter 1 Getting Started— Principles of Finance – Copyright © © 2021 2021 Pearson Pearson Education Education Ltd. Ltd. Copyright Learning Objectives (1 of 2) 1. Understand the importance of finance in your personal and professional lives and identify the three primary business decisions that financial managers make. 2. Identify the key differences among the three major legal forms of business. Copyright © 2021 Pearson Education Ltd. Learning Objectives (2 of 2) 3. Understand the role of the financial manager within the firm and the goal for making financial choices. 4. Explain the five principles of finance that form the basis of financial management for both businesses and individuals. Copyright © 2021 Pearson Education Ltd. 1.1 FINANCE: AN OVERVIEW Copyright © 2021 Pearson Education Ltd. What is Finance? Finance is the study of how people and businesses evaluate investments and raise capital to fund them. Copyright © 2021 Pearson Education Ltd. Three Basic Questions Addressed by the Study of Finance: 1. What long-term investments should the firm undertake? (capital budgeting decision) 2. How should the firm raise money to fund these investments? (capital structure decision) 3. How can the firm best manage its cash flows as they arise in its day-to-day operations? (working capital management) Copyright © 2021 Pearson Education Ltd. Why Study Finance? • Knowledge of financial tools is critical to making good decisions in both corporate world and personal lives. – How will GM’s strategic decision to invest $500 million in Lyft, the ride-hailing start-up, require the expertise of different disciplines within the business school? Copyright © 2021 Pearson Education Ltd. 1.2 THREE TYPES OF BUSINESS ORGANIZATIONS Copyright © 2021 Pearson Education Ltd. Business Organizational Forms Business Forms Sole Proprietorships Partnerships General Corporations Limited Copyright © 2021 Pearson Education Ltd. Sole Proprietorship—Meaning • It is a business owned by a single individual who is entitled to all of the firm’s profits and is also responsible for all of the firm’s debt. • The sole proprietors typically raise money by investing their own funds and by borrowing from a bank. Copyright © 2021 Pearson Education Ltd. Sole Proprietorship—Advantages • Advantages: – Easy to form – No need to consult others while making decisions – Profits are taxed at the owner’s tax rate Copyright © 2021 Pearson Education Ltd. Sole Proprietorship—Disadvantages • Disadvantages: – Personally liable for the business debts – The business ceases on the death of the proprietor – Limited access to external sources of financing Copyright © 2021 Pearson Education Ltd. Partnership—Meaning A general partnership is an association of two or more persons who come together as co-owners for the purpose of operating a business for profit. Copyright © 2021 Pearson Education Ltd. Partnership—Advantages & Disadvantages • Advantages: – Relatively easy to start – Taxed at the personal tax rate – Access to funds from multiple partners • Disadvantages: – Partners jointly share unlimited liability – It is not always easy to transfer ownership Copyright © 2021 Pearson Education Ltd. Limited Partnerships • In limited partnerships, there are two classes of partners: general and limited. • The general partner runs the business and faces unlimited liability for the firm’s debts, whereas the limited partner is liable only up to the amount the limited partner invested. The life of the partnership is tied to the life of the general partner. Copyright © 2021 Pearson Education Ltd. Corporation • If very large sums of money are needed to build a business, then the typical organizational form chosen is the corporation. Corporation legally functions separately and apart from its owners (the shareholders). Corporation can individually sue and be sued and can purchase, sell, or own property. • The corporation is legally owned by its current set of stockholders, or owners. The Board of directors are elected by the shareholder, and the board appoints the senior management of the firm. Copyright © 2021 Pearson Education Ltd. Corporation—Advantages • Advantages – Liability of owners is limited to invested funds – Life of corporation is not tied to the status of the investors – Easier to raise Capital Copyright © 2021 Pearson Education Ltd. Corporation—Disadvantages • Disadvantages – Greater regulation – Double taxation of dividends Copyright © 2021 Pearson Education Ltd. Not-for-Profit Organization • Created with specific objectives of promoting a social cause Copyright © 2021 Pearson Education Ltd. Not-for-Profit Organization – Advantages • Either exempt from taxes or pay lower taxes than corporations • Surplus from operations possible but not primary criterion Copyright © 2021 Pearson Education Ltd. Not-for-Profit Organization – Disadvantages • Required to manage risk and evaluate projects nevertheless Copyright © 2021 Pearson Education Ltd. Co-operative • Owned and governed by its members, usually also its buyers Copyright © 2021 Pearson Education Ltd. Co-operative – Advantages • Favorable regulations in many countries to promote them Copyright © 2021 Pearson Education Ltd. Co-operative – Disadvantages • Cannot issue shares to external investors • Require special financing methods to raise capital Copyright © 2021 Pearson Education Ltd. Figure 1.1 How the Finance Area Fits into a Corporation Copyright © 2021 Pearson Education Ltd. 1.3 THE GOAL OF THE FINANCIAL MANAGER Copyright © 2021 Pearson Education Ltd. The Goal of the Financial Manager • The goal of the financial manager must be consistent with the mission of the corporation, which is to maximize shareholder’s wealth. • While shareholder wealth maximization is included in Coca-Cola’s vision statement, it also includes other broader goals (such as social responsibility) that will ultimately benefit shareholders in the long-run. Copyright © 2021 Pearson Education Ltd. Coca-Cola’s Vision Statement To achieve sustainable growth, we have established a vision with clear goals for: – Profit – People – Portfolio – Partners – Planet Copyright © 2021 Pearson Education Ltd. Corporate Mission • While managers have to cater to all the stakeholders (such as consumers, employees, suppliers etc.), they need to pay particular attention to the shareholders. • If managers fail to pursue shareholder wealth maximization, they will lose the support of investors and lenders. The business may cease to exist and ultimately, the managers will lose their jobs! Copyright © 2021 Pearson Education Ltd. Ethical Considerations in Corporate Finance • What do we mean by Ethics? • Give examples of recent financial scandals and discuss what went wrong from an ethical perspective. Copyright © 2021 Pearson Education Ltd. The Sarbanes—Oxley Act (SOX) • SOX Act was passed in 2002 “to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes”. • SOX Act mandates senior executives to take individual responsibility for the accuracy and completeness of the firm’s financial reports. Copyright © 2021 Pearson Education Ltd. 1.4 THE FIVE BASIC PRINCIPLES OF FINANCE Copyright © 2021 Pearson Education Ltd. Principle 1: Money Has a Time Value • A dollar received today is worth more valuable than a dollar received in the future. • We can invest the dollar received today to earn interest. Thus, in the future, we will have more than one dollar, as we will have earned interest on the investment. Copyright © 2021 Pearson Education Ltd. Principle 2: There is a Risk—Return Trade—off • Investors tend to be risk-averse and prefer certain return to an uncertain return. Investors will hold risky investments if they expect to be compensated with additional return. • Higher the risk, higher will be the expected return. Note expected return may not be equal to the realized rate of return. Thus higher risk does not guarantee higher rate of return. Copyright © 2021 Pearson Education Ltd. Figure 1.3 There is a Risk-Return Trade—off Copyright © 2021 Pearson Education Ltd. Principle 3: Cash Flows Are the Source of Value • Profit is an accounting concept and measures a business’s performance. Cash flow is the amount of cash that can actually be taken out of the business. • Company’s profits can differ dramatically from its cash flows. It is possible for a company to report profits without generating any cash. Copyright © 2021 Pearson Education Ltd. Incremental Cash Flow Financial decisions in a firm should consider marginal, or “incremental”, cash flows i.e. the difference between the cash flows the company will produce with the potential new investment and the cash flows that would be produced without the investment. Copyright © 2021 Pearson Education Ltd. Principle 4: Market Prices Reflect Information Investors respond to new information by buying and selling their investments. The speed of investor reaction and speed of price adjustment determines the efficiency of market. Release of Good News ==> Higher stock prices Release of Bad News ==> Lower stock price Copyright © 2021 Pearson Education Ltd. Principle 5: Individuals Respond to Incentives Managers (as agents) respond to incentives they are given in the workplace. If the incentives are not properly aligned with those of the firm’s stockholders (the principal) they may not make decisions that are consistent with increasing shareholder value leading to agency costs. Copyright © 2021 Pearson Education Ltd. Mitigating Agency Costs The agency problems/costs can be mitigated through: 1. Compensation plans that reward managers when they act to maximize shareholder wealth 2. Monitoring by the board of directors 3. Monitoring by financial markets (such as auditors, bankers, security analysts, credit agencies) 4. The underperforming firms seeing their stock prices fall and face threat of being taken over and have their management teams replaced. Copyright © 2021 Pearson Education Ltd. Key Terms (1 of 3) • Agency problem • Capital budgeting • Capital structure • Co-operative • Corporation • Debt • Dividends • Equity Copyright © 2021 Pearson Education Ltd. Key Terms (2 of 3) • Financial markets • General partner • General partnership • Limited liability company (LLC) • Limited partner • Limited partnership • Not-for-Profit • Opportunity cost Copyright © 2021 Pearson Education Ltd. Key Terms (3 of 3) • Partnership • Shareholders • Shares • Sole proprietorship • Stockholders • Working capital management Copyright © 2021 Pearson Education Ltd.
