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

Slide Contents What is Finance? The Goal of the Firm Legal Forms of Business Organization Role of Financial Manager in a Corporation Income Taxation Ten Principles of Finance Finance and Multinational Firm © 2011 Pearson Prentice Hall. All rights reserved.

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. 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. 4

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.

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.

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.

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.

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.

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

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.

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.

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.

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.

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.

The Role of a Financial Manager in a Firm © 2011 Pearson Prentice Hall. All rights reserved. 16

4. The Legal Forms of Business Organization © 2011 Pearson Prentice Hall. All rights reserved. 17

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. 18

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. 19

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. 20

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. 21

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.

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.

S-Type Corporations Benefits Limitations 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. 24

Limited Liability Companies (LLC) 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. 25

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. 26

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.

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.

Review: Key Terms Agency problem Corporation Efficient market General partnership Incremental cash flow LLC Limited Partnership Partnership Sole proprietorship S-type corporation © 2011 Pearson Prentice Hall. All rights reserved.