2 An Introduction to the Foundations of Financial Management—The Ties That Bind
3 Chapter Objectives Identify the Goal of the Firm Compare the various legal forms of business organizationDescribe the corporate tax features that affect business decisionsDescribe the impact of the tragedies of September 11 on corporate financeExplain the 10 principles that form the foundations of financial managementExplain what has led to the era of the multinational corporation
4 The Goal of the FirmThe Goal of the firm is maximization of shareholder wealthorMaximization of the price of the existing common stock
5 Benefits of Maximizing Shareholder Wealth Direct benefit to shareholdersSocietal benefits as businesses compete to create wealthIncludes effects of all financial decisions
6 Profit Maximization Stresses the efficient use of capital resources Not specific to time frame for profits to be measuredGoals are not precise, allow for misinterpretationIgnores uncertainty and timing
7 Legal Forms of Business Organization Sole ProprietorshipPartnershipCorporation
8 Sole Proprietorship Owned by an individual Owner holds title to assets Unlimited liabilityTermination occurs on owner’s death or by owner’s choice
9 Partnerships Two or more owners Limited Partnership Allows one or more partners limited liabilityMust have one general partner with unlimited liabilityNames of limited partners may not appear in name of firmLimited partners may not participate in management decisions.General PartnershipEach partner is fully responsible for liabilitiesorJoint Unlimited Liability
10 Corporation Most large companies are corporations Separate legal entityCan sue, be sued, purchase, sell and own propertyShareholders are the legal ownersLife continues with transfer of ownershipTaxed separately
12 Objectives of Income Taxation Raise revenues for government expendituresAchieve socially desirable goalsAchieve economic stabilization
13 Types of TaxpayersIndividuals—employees, self-employed persons, members of partnershipsReport income on personal tax returnCorporations—separate legal entityReport income on corporate tax returnDistributed dividends taxed to shareholdersFiduciaries—estates and trustsPay taxes on undistributed income
14 Taxable IncomeTaxable Income—Gross income less tax deductible expenses, plus Interest income and dividend incomeGross Income—Dollar sales from a product or service less cost of production or acquisitionTax Deductible Expenses—Operating expenses (marketing, depreciation, administrative expenses) and interest expenseDividends paid are not deductible
15 Corporate Income Sales $1,000 Cost of Goods Sold $ 200 Gross Profit $ 800Operating ExpensesAdministrative Expenses $150Depreciation Expense $ 50Total Operating Expenses $200Operating Income $600Other Income $0Interest Expense $250Taxable Income $350
16 Corporate Tax Rates Income Rate $ 0 - $50,000 15% $ 0 - $50, %$50,001 - $75, %$75,001 - $10,000, %Over $10,000, %Additional surtax:5% on income between $100,000 and $335,0003% on income between $15,000,000 and $18,333,333
17 Marginal Tax Rates Rates applicable to next dollar of income Used in financial decision-making
18 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 lifeCapital Gains and Losses—Capital Gains taxed as ordinary income. Capital losses cannot be deducted from ordinary income.
19 Ten Principles That Form The Foundations of Financial Management
20 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 will be its expected return.
21 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.
22 Principle 3: Cash—Not Profits—Is King Cash Flow, not accounting profit, is used to measure wealth.Cash flows, not profits, are actually received by the firm and can be reinvested.
23 Principle 4: Incremental Cash Flows It is only what changes that countsThe 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
24 Principle 5: The Curse of Competitive Markets Why it is hard to find exceptionally profitable projectsIf 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
25 Principle 6: Efficient Capital Markets The markets are quick and the prices are rightThe values of all assets and securities at any instant in time fully reflect all available information.
26 Principle 7: The Agency Problem Managers won’t work for the owners unless it is in their best interestThe 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
27 Principle 8: Taxes Bias Business Decisions When a new project is evaluated, the after-tax incremental cash flows are considered
28 Principle 9: All Risk is Not Equal Some risk can be diversified away, and some cannotDiversification allows good and bad events or observations to cancel each other out, thus reducing total variability without affecting expected return
29 Principle 10: Ethical Behavior Is Doing The Right Thing, and Ethical Dilemmas Are Everywhere In FinanceEach person has his or her own set of values, which forms the basis for personal judgments about what is the right thing
30 Finance And The Multinational Firm U.S. corporations are looking to international expansionCollapse of communismFree market system developing in the third worldFreer access to international markets