Chapter 1

An Introduction
to the
Foundations
of Financial
Management

Copyright © 2011 Pearson Prentice Hall.

All rights reserved.
 Learning Objectives

 Identify the goal of the firm.

 Understand the five basic principles of finance and
business, the consequences of forgetting those
basic principles of finance, and the importance of
ethics and trust in business.
 Describe the role of finance in business.
 Distinguish between the different legal forms of
business.
 Explain what has led to the era of the multinational
corporation.

© 2011 Pearson Prentice Hall. All rights reserved. 1-2

 Slide Contents

1. What is Finance?
2. The Goal of the Firm
3. Legal Forms of Business Organization
4. Role of Financial Manager in a
Corporation
5. Income Taxation
6. Ten Principles of Finance
7. Finance and Multinational Firm
© 2011 Pearson Prentice Hall. All rights reserved. 1-3
 What is Finance?

Finance applies specific value to

things owned
services used
decisions made
Financial management
organization’s approach to
valuation

© 2011 Pearson Prentice Hall. All rights reserved. 1-4

 1. The Goal of the Firm

 The goal of the firm is to create value for the

firm’s legal owners (that is, its shareholders).
Thus the goal of the firm is to “maximize
shareholder wealth” by maximizing the price
of the existing common stock.

© 2011 Pearson Prentice Hall. All rights reserved. 1-5

 2. Five Foundational
Principles of Finance

 Cash flow is what matters

 Money has a time value
 Risk requires a reward
 Market prices are generally right
 Conflicts of interest cause agency
problems

© 2011 Pearson Prentice Hall. All rights reserved. 1-6

 Five Principles

“…while 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.”

© 2011 Pearson Prentice Hall. All rights reserved. 1-7

 Principle 1:
Cash flow is what matters

 Accounting profits are not equal to cash flows. It is

possible for a firm to generate accounting profits but
not have cash or to generate cash flows but not
report accounting profits in the books.
 Cash flow, and not profits, drive the value of a
business.
 We must determine incremental cash flows when
making financial decisions.
 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.

© 2011 Pearson Prentice Hall. All rights reserved. 1-8

 Principle 2:
Money has a time value

 A dollar received today is worth more than a

dollar received in the future.
 Since we can earn interest on money received
today, it is better to receive money earlier rather
than later.

© 2011 Pearson Prentice Hall. All rights reserved. 1-9

 Principle 3:
Risk requires a Reward

 We won’t take on additional risk unless we

expect to be compensated with additional
reward or return.
 Investors expect to be compensated for
“delaying consumption” and “taking on risk”.
 Thus investors expect a return when they put their
savings in a bank (i.e. delay consumption) and
they expect to earn a higher rate of return on
stocks relative to bank savings account (i.e. taking
on risk)

© 2011 Pearson Prentice Hall. All rights reserved. 1-10

 Figure 1-1

© 2011 Pearson Prentice Hall. All rights reserved. 1-11

 Principle 4: Market Prices
are generally Right

 In an efficient market, the prices of all traded assets

(such as stocks and bonds) at any instant in time fully
reflect all available information.
 Thus stock prices are a useful indicator of the value
of the firm. Prices changes reflect changes in
expected future cash flows. Good decisions will tend
to increase the stock prices and vice versa.
 Note there are inefficiencies in the market that may
distort the prices.

© 2011 Pearson Prentice Hall. All rights reserved. 1-12

 Principle 5: Conflicts of interest
cause agency problems

 The separation of management and the

ownership of the firm creates an agency
problem. Managers may make decisions that
are not consistent with the goal of maximizing
shareholder wealth.
 Agency conflict is reduced through monitoring
(ex. Annual reports), compensation schemes
(ex. stock options), and market mechanisms
(ex. Takeovers)

© 2011 Pearson Prentice Hall. All rights reserved. 1-13

 Ethics and business

 Ethical behavior is doing the right thing! …

but what is the right thing?
 Ethical dilemma - Each person has his or her
own set of values, which forms the basis for
personal judgments about what is the right
thing.
 Sound ethical standards are important for
business and personal success. Unethical
decisions can destroy shareholder wealth
(ex. Enron Scandal)
© 2011 Pearson Prentice Hall. All rights reserved. 1-14
 3. The Role of Finance
in Business

Three broad issues addressed by the study of

finance:
 Where to Invest? (Capital budgeting
decision)
 How to raise money to fund the investment?
(Capital structure decision)
 How to manage cash flows from daily
operations? (Working capital decision)

© 2011 Pearson Prentice Hall. All rights reserved. 1-15

 The Role of Business in
Finance (cont.)

 Knowledge of financial tools is relevant for

decision making in all areas of business
(be it marketing, production etc.).
 Decisions involve an element of time and
uncertainty … financial tools help adjust for
time and risk.
 Decisions taken in business should be
financially feasible … financial tools help
determine the financial viability of decisions.

© 2011 Pearson Prentice Hall. All rights reserved. 1-16

 The Role of a Financial
Manager in a Firm

© 2011 Pearson Prentice Hall. All rights reserved. 1-17

 4. The Legal Forms of
Business Organization

Business Forms

Sole
Partnership Corporation Hybrid
Proprietorship

S-Type LLC

© 2011 Pearson Prentice Hall. All rights reserved. 1-18

 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

© 2011 Pearson Prentice Hall. All rights reserved. 1-19

 Partnerships

 Two or more persons come together as co-owners

 General Partnership: All partners are fully responsible
for liabilities incurred by the partnership.
 Limited Partnerships: One or more partners can have
limited liability, restricted to the amount of capital
invested in the partnership. There must be at least one
general partner with unlimited liability. Limited partners
cannot participate in the management of the business
and their names cannot appear in the name of the firm.

© 2011 Pearson Prentice Hall. All rights reserved. 1-20

 Corporation

 Legally functions separate and apart from its owners

 Corporation can sue, be sued, purchase, sell, and own property
 Owners (shareholders) dictate direction and policies of
the corporation, oftentimes through elected board of
directors.
 Shareholder’s liability is restricted to amount of
investment in company
 Life of corporation does not depend on the owners …
corporation continues to exist through easy transfer of
ownership
 Taxed separately
© 2011 Pearson Prentice Hall. All rights reserved. 1-21
 The trade-offs:
Corporate Form

 Benefits: Limited liability, Easy to transfer

ownership, Easier to raise capital, Unlimited
life (unless the firm goes through corporate
restructuring such as mergers and
bankruptcies)
 Drawbacks: No secrecy of information,
maybe delays in decision making, Greater
regulation, double taxation.

© 2011 Pearson Prentice Hall. All rights reserved. 1-22

 Double Taxation example

 Assume earnings before tax = $1,000

 Federal Tax @25% = $250
 After tax Income available for distribution to
shareholders= $750
 Examine the tax effects, if the company
chooses to distribute the after-tax profits to
shareholders as dividends.

© 2011 Pearson Prentice Hall. All rights reserved. 1-23

 Double Taxation example

 If corporation distributes all the profits as

dividends to shareholders ==> Shareholders
will be taxed again.
 Assume dividends are taxed @15%
 = 15% of $750 = $112.50

==>Total tax = 250 + 112.5 = $362.5 or 36.25%

© 2011 Pearson Prentice Hall. All rights reserved. 1-24

 Hybrid Organizations:
S-Type Corporation and
Limited liability Companies (LLC)

 S-Type Corporations
 Benefits
 Limited liability
 Taxed as partnership (no double taxation like
corporations)
 Limitations
 Owners must be people so cannot be used for
joint ventures between two corporations

© 2011 Pearson Prentice Hall. All rights reserved. 1-25

 Hybrid Organizations:
S-Type Corporation and
Limited liability Companies (LLC) (cont.)

 Limited Liability Companies (LLC)

 Benefits
 Limited liability
 Taxed like a partnership
 Limitations
 Qualifications vary from state to state
 Cannot appear like a corporation otherwise it
will be taxed like one

© 2011 Pearson Prentice Hall. All rights reserved. 1-26

 5. Finance and the Multinational
Firm: The New Role

 U.S. corporations are looking to international

expansion to discover profits
 For example, Coca-Cola earns over 80% of its profits from
overseas sales
 In addition to US firms going abroad, we have also
witnessed many foreign firms making their mark in
the United States (ex. Domination of auto industry by
Honda, Toyota, and Nissan)
 Internationalization of business has been spurred by:
 Collapse of communism
 Acceptance of free market system
 Technology
 Improved transportation

© 2011 Pearson Prentice Hall. All rights reserved. 1-27

 Why do companies
go abroad?

 To increase revenues
 To reduce expenses (land, labor, capital, raw
material, taxes)
 To lower governmental regulation standards
(ex. Environmental, labor)
 To increase global exposure

© 2011 Pearson Prentice Hall. All rights reserved. 1-28

 Risks/challenges

 Country risk (changes in government

regulations, unstable government, economic
changes in foreign country)
 Currency risk (fluctuations in exchange rates)
 Cultural risk (differences in language,
traditions, ethical standards etc.)

© 2011 Pearson Prentice Hall. All rights reserved. 1-29

 Review: Key Terms

 Agency problem  LLC

 Corporation  Limited Partnership
 Efficient market  Partnership
 General partnership  Sole proprietorship
 Incremental cash  S-type corporation
flow

© 2011 Pearson Prentice Hall. All rights reserved. 1-30