Chapter 1 Principles of Finance Updated 2-2015

Important Roles of Corporate Financial Managers: What long-term investments should the firm undertake? (Capital budgeting or Investing decision) How should the firm finance these investments? (Capital structure or Financing decision) How the firm manage its cash flows as they arise from day-to-day operations? (Working capital management decision) How the firm distribute cash back to shareholders? (Distribution policy – cash dividend payments)

Business Organizational Forms Business Forms Sole Proprietorships Partnerships Corporations

Sole Proprietorship A business owned by a single individual who is entitled to all of the firm’s profits and is responsible for all of the firm’s debt. There is no separation between the business and the owner when it comes to debts or being sued (unlimited liabilities). Sole proprietorships are generally financed by personal loans from family & friends as well as business loans from banks.

Sole Proprietorship (cont.) Advantages: Easy to start No need to consult others while making decisions Taxed at the personal tax rate Disadvantages: Personally liable for the business debts (unlimited liabilities) Ceases on the death of the proprietor

Partnership A general partnership: A business form in which two or more persons joining together as co-owners (partners) for the purpose of operating a business for profit. All owners are general partners. There is no separation between the partnership and the owners with respect to debts or being sued (unlimited liabilities).

Partnership (cont.) Advantages: Disadvantage: Relatively easy to start Taxed at the personal tax rate Access to funds from multiple sources or partners Disadvantage: Partners jointly share unlimited liability

Partnership (cont.) In limited partnerships, there are two groups of partners: General partners (unlimited liabilities) Limited partners (limited liabilities) The general partners runs the business and face unlimited liability for the firm’s debts, while the limited partners are only liable on the amount invested in the business.

Corporation Corporation is a legal entity which is owned by its current shareholders. Corporation can individually sue and be sued, buy, sell or own property, and its personnel are subject to criminal punishment for crimes committed in the name of the corporation. The Board of directors are elected by the firm’s shareholders. One responsibility of the board of directors is to appoint the senior management of the firm.

Corporation (cont.) Advantages: Disadvantages: Liability of owners limited to invested funds (limited liabilities) Life of corporation is not tied to the owner Easier to transfer ownership Easier to raise capital Disadvantages: Greater regulation Double taxation of dividends

Figure 2

The Goal of the Corporation To maximize shareholder’s wealth (as measured by share prices) = To maximize firm value While managers have to cater to all stakeholders (i.e. consumers, employees, suppliers, shareholders etc.), they need to pay particular attention to the owners of the corporation (shareholders). If managers fail to pursue shareholder wealth maximization, they will lose the support from them. The business may cease to exist and ultimately, the managers will lose their jobs!

Ethics in Finance What do we mean by ethics? Acting in an ethical manner morally correct Ethics is a necessary ingredient to long-term business and personal success To maximize shareholders’ wealth, corporation must conduct its business in an ethical way.

PRINCIPLE 1: Time Value of Money. A dollar received today is more valuable than a dollar received in the future. We can invest the dollar received today to earn interest. Thus, in the future, you will have more than one dollar, as you will receive the interest on your investment plus your initial invested dollar. 1st Choice = Receive $1 M. today 2nd Choice = Receive $1 M. next year

PRINCIPLE 2: Risk-Return Trade-off. We only take risk when we expect to be compensated for (the extra risk) with additional return. The higher the risk, the higher will be the expected return. Realized return >=< Expected return 1st Choice = Buy T-bills 2nd Choice = Buy stocks

Figure 3

PRINCIPLE 3: Cash Flows Are The Source of Value. Profit vs. Cash Profit is an accounting concept used to measure business performance over an interval period. Cash flow is the amount of cash that can actually be taken out of the business over this same interval. It is possible for a firm to report profits but have no cash. For example, if all sales are on credit, the firm may report profits even though no cash is being generated. But “Cash is King” since firm can only use cash to pay for employee salary, debt, dividend.

Incremental Cash Flow Financial decisions in a firm should consider “incremental cash flow” i.e. the difference between the cash flows the company will generate with the potential new investment and what it would make without such investment. Project A = Existing product Project B = New product CF (A&B) CF (A only) Incremental CF $3 M. $1 M. $2 M.

PRINCIPLE 4: Market Prices Reflect Information. Investors respond to new information by buying and selling securities. Investors in stock markets tend to react positively to good decisions or good news made by the firm resulting in higher stock prices. Whereas stock prices tend to decrease when there is bad news about the firm. Thus, the market prices of stocks reflect information.

PRINCIPLE 5: Principal & Agent Conflicts In a corporation, the managers are the agents and the shareholders are the principal. Agency problems arise when there is conflict of interest between the shareholders and the managers. Examples: Not pursuing risky project for fear of losing jobs, stealing firm’s assets, expensive perks (employee benefits), insider trading etc. Agency problems reduce firm value.

PRINCIPLE 5: Principal & Agent Conflicts The agency problems/costs can be mitigated through: Compensation plans that reward managers when they act to maximize shareholder wealth Monitoring by the board of directors Monitoring by financial markets (i.e. accounting auditors, banks, security analysts, credit agencies) The above measures help reducing agency problems

Personal Summary Write down one thing you learned in this chapter that is interesting, new, or useful to you. ____________________________________________________________________________________________________________________________________________