Foundations of Finance
Arthur J. Keown
John D. Martin
J. William Petty
David F. Scott, Jr.
Chapter 1
An Introduction to the Foundations
of Financial Management
The Ties that Bind
Chapter Objectives
• 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.
• Explain the 10 principles that form the foundations of
financial management.
• Explain what has led to the era of the multinational
corporation.
The Goal of the Firm
• The goal of the firm is maximization of
shareholder wealth
or
• Maximizing the price of the existing
common stock
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
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
Legal Forms of Business
Organization
• Sole Proprietorship
• Partnership
• Corporation
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
Partnerships
• Two or more owners
 General Partnership
• Each partner is fully responsible for liabilities
 Limited Partnerships
Partnerships
Limited Partnership and Limited Liability Company
• Allows one or more partners limited liability based on
amount of capital invested
• Must have one general partner with unlimited liability
• Names of limited partners may not appear in name of
firm
• Limited partners may not participate in management
decisions
Corporation
• Legally functions separate and apart from its owners
• Can sue, be sued, purchase, sell, and own property
• Owners who dictate direction and policies
• Elect a board of directors
• Investors liability is restricted to amount of investment in
company
• Life continues with transfer of ownership
• Taxed separately
Comparison of
Organizational Forms
Large growing firms choose the corporate form
• Ease in raising capital
• Limited liability
• Transfer of ownership is simple
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
Organizational Form
and Taxes
Corporation
• Double taxation of dividends
• Tax Act of 2003 limited the tax rate on
dividends to stimulate the economy
• Ended in 2008. Congress took action and extended until
2012.
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
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
The Role of the Financial
Manager in a Corporation
HOW THE FINANCE AREA FITS INTO A CORPORATION
Objectives of Income Taxation
• Raise revenues for government
expenditures
• Achieve socially desirable goals
• Economic stabilization
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
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
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
Corporate Tax Rates
Income
Rate
$0 - $50,000
$50,001 - $75,000
$75,001 - $10,000,000
Over $10,000,000
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
Marginal Tax Rates
• Rates applicable to next dollar of income
• Used in financial decision-making
Other Corporate Tax
Considerations
Dividend Exclusion
• A corporation may typically exclude 70% of any dividend
received from another corporation.
Depreciation Expense
• 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.
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.
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.”
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.
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.
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.
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
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.
Principle 8:
Taxes Bias Business Decisions
• The cash flows we consider are the
after-tax incremental cash flows to the
firm as a whole.
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.
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.
Principle 10:
Ethical Behavior Is Doing the Right Thing.
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
Finance and
the Multinational Firm
U.S. corporations are looking to 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