Financial Management: Principles & Applications Thirteenth Edition Chapter 1 Getting Started— Principles of Finance Copyright Education, © 2018, 2014, 2011 Pearson Inc. All Reserved Rights Reserved Copyright © 2018, 2014, 2011 Pearson Inc. Education, All Rights 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 1.1 FINANCE: AN OVERVIEW Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved What is Finance? Finance is the study of how people and businesses evaluate investments and raise capital to fund them. Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 1.2 THREE TYPES OF BUSINESS ORGANIZATIONS Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved Business Organizational Forms •Business Forms •Sole •Proprietorships •Partnerships • General • Limited • Corporations Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved Corporation—Disadvantages • Disadvantages – Greater regulation – Double taxation of dividends Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved Limited Liability Company (LLC) Limited liability company (LLC) combines the tax benefits of a partnership (no double taxation of earnings) with the limited liability benefit of corporation (the owner’s liability is limited to what they invested). Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved Figure 1.1 Characteristics of Different Forms of Business (1 of 2) Business Form Number of Owners Are Owners Liable for the Firm’s Debts? Sole Proprietorship One Yes Yes Yes Very limited Personal Taxes Partnership Unlimited Yes; each partner has unlimited Liability Yes Yes Very limited Personal Taxes Limited Partnership (with General Partners [GPs] and Limited Partners [LPs]) At least one GP, but no limit on LPs GPs— unlimited liability LPs—limited liability GPs—manage the firm LPs— no role in management GPs—yes LPs—no, can change1 Limited Personal Taxes 1It Do Owners Manage the Firm? Does an Ownership Change Dissolve the Firm? Access to Capital Taxation is common for LPs to require approval from the other partners before a partner’s ownership can be transferred. Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved Figure 1.1 Characteristics of Different Forms of Business (2 of 2) Number of Owners Are Owners Liable for the Firm’s Debts? Do Owners Manage the Firm? Does an Ownership Change Dissolve the Firm? Limited Liability Company (LLC) Unlimited No Yes Corporation Unlimited No No—although managers generally have an ownership Stake2 Business Form 2Owners Access to Capital Taxation No Dependent on size Personal Taxes No Very easy Access Double Taxation: Earnings taxed at corporate level Dividends taxed at personal level are not prohibited from managing the corporation. Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved Figure 1.2 How the Finance Area Fits into a Corporation Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 1.3 THE GOAL OF THE FINANCIAL MANAGER Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved Coca-Cola’s Vision Statement To achieve sustainable growth, we have established a vision with clear goals for: – Profit – People – Portfolio – Partners – Planet Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 1.4 THE FIVE BASIC PRINCIPLES OF FINANCE Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved Figure 1.3 There is a Risk-Return Trade—off Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved 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 © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved Key Terms (1 of 3) • Agency problem • Capital budgeting • Capital structure • Corporation • Debt • Dividends • Equity Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved Key Terms (2 of 3) • Financial markets • General partner • General partnership • Limited liability company (LLC) • Limited partner • Limited partnership • Opportunity cost Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved Key Terms (3 of 3) • Partnership • Shareholders • Shares • Sole proprietorship • Stockholders • Working capital management Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved Copyright Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
