Chapter 1 An Introduction

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Chapter 1 An Introduction
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Chapter Objectives

• Identify the Goal of the Firm
• Explain the 10 principles that form the
  foundations of financial management

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The Goal of the Firm

• Maximization of shareholder wealth
• or
• Maximization of the price of the existing common
  stock

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Profit Maximization

• Stresses the efficient use of capital resources
• Problems
• 1) Not specific to time frame for profits
  to be measured
• 1 year? longer?
• 2) Goals are not precise, allow for
  misinterpretation
• Example could increase current
  profits by deferring
• maintenance expenses or eliminating
  RD expenditures

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3) Too simplistic in that it assumes away the
problems of uncertainty and timing of
returns gt There is a definite relationship
between risk and expected return (Chapter
6) gt Given equivalent cash flows
from profits, we want those cash flows
sooner rather than later (Chapter 5)
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Benefits of Maximizing Shareholder Wealth

• Direct benefit to shareholders
• Societal benefits as businesses compete to create
  wealth
• - Scarce resources are directed to their most
  productive use
• Includes effects of all financial decisions
• - Shareholders react to poor investment or
  dividend decisions
• by causing the total value of the firms
  stock to fall, and react
• to good decisions by pushing the price of
  stock upward

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Legal Forms of Business Organization

• Sole Proprietorship
• Partnership
• Corporation

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Sole Proprietorship

• Owned by an individual
• Owner holds title to assets
• Unlimited liability
• Termination occurs on owners death or by owners
  choice

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Partnerships

• Two or more owners

• Limited Partnership
• Allows one or more partners limited liability
• 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.

• General Partnership
• Each partner is fully responsible for liabilities
  
• or
• Joint Unlimited Liability

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Corporation

• Most large companies are corporations
• Separate legal entity
• Can sue, be sued, purchase, sell and own property
• Shareholders are the legal owners
• Life continues with transfer of ownership
• Taxed separately

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• Advantages and Disadvantages
• Establishment and regulation
• Owners liability
• Raising fund
• Entity continuity
• Taxation

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Taxable Income

• Taxable IncomeGross income less tax deductible
  expenses, plus Interest income and dividend
  income
• Gross IncomeDollar sales from a product or
  service less cost of production or acquisition
• Tax Deductible ExpensesOperating expenses
  (marketing, depreciation, administrative
  expenses) and interest expense
• Dividends paid are not deductible

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Corporate Income

• Sales 1,000
• Cost of Goods Sold 200
• Gross Profit 800
• Operating Expenses
• Administrative Expenses 150
• Depreciation Expense 50
• Total Operating Expenses 200
• Operating Income 600
• Other Income 0
• Interest Expense 250
• Taxable Income 350

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Corporate Tax Rates

• Income Rate
• 0 - 50,000 15
• 50,001 - 75,000 25
• 75,001 - 10,000,000 34
• Over 10,000,000 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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Marginal Tax Rates

• Rates applicable to next dollar of income
• Used in financial decision-making

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Other Corporate Tax Considerations

• Dividend ExclusionA corporation may typically
  exclude 70 of any dividend received from another
  corporation.
• Depreciation ExpenseA corporation may expense an
  assets cost over its useful life
• Capital Gains and LossesCapital Gains taxed as
  ordinary income. Capital losses cannot be
  deducted from ordinary income.

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How Do Taxes Affect FinancialDecision Making

• Investment Decisions
• After-tax basis
• Depreciation
• Estimated salvage value
• Capital Structure
• Interest expense tax shield
• Dividend Policies
• Capital gains vs. dividends

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Ten Principles That Form The Foundations of
Financial Management
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• 1) Risk - return trade-off
• 2) Time value of money
• 3) Cash is king
• 4) Incremental cash flows count
• 5) Its hard to find really profitable projects
• 6) Efficient capital markets
• 7) The agency problem
• 8) Taxes bias business decisions
• 9) All risk is not equal
• 10) Ethical dilemmas are everywhere in finance

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Principle 1 The Risk-Return Trade-off

• We wont 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 will
  be its expected return.
• (See how does the goal of maximizing
  shareholders wealth take risk into account?
  Chapter 6)

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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.
• (Present value vs. future value. Chapter 5)

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Principle 3 CashNot ProfitsIs King

• Cash Flow, not accounting profit, is used to
  measure wealth.
• Accounting profit accrual base,
• depreciation,
  etc.
• Cash flows, not profits, are actually received by
  the firm and can be reinvested.
• (Chapter 10)

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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 accepted, versus what they will be, if the
  project is not accepted

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Principle 5 The Curse of Competitive Markets

• Why 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

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• How can we find good projects
• (i.e., projects that return more than their
• expected rate of return given their risk level)?
• Invest in markets that are not perfectly
• competitive by
• Differentiating the product
• (e.g., advertising, patents, service and
  quality)
• Achieving a cost advantage
• (e.g., economies of scale and producing at
• a cost below the competition)

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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.
• Information is reflected in security prices
  with such speed that there are no opportunities
  for investors to profit from publicly available
  information

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Principle 7 The Agency Problem

• Managers wont 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

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Principle 8 Taxes Bias Business Decisions

• When a new project is evaluated, the after-tax
  incremental cash flows are considered
• Government use taxes to encourage spending in
  certain ways e.g., investment tax credit

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Principle 9 All Risk is Not Equal

• Some risk can be diversified away, and some
  cannot
• Diversification allows good and bad events or
  observations to cancel each other out, thus
  reducing total variability without affecting
  expected return

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Principle 10 Ethical Behavior Is Doing The
Right Thing, and Ethical Dilemmas Are Everywhere
In Finance

• Ethics, or rather the lack of ethics in finance,
  is a recurring theme in the news
• Each person has his or her own set of values,
  which forms the basis for personal judgments
  about what is the right thing
• Ethical conduct involves abiding by societys
  rules