Chapter 1

An Introduction to the Foundations of Financial Management—The Ties That Bind

Chapter Objectives Identify the Goal of the Firm Compare the various legal forms of business organization Describe the corporate tax features that affect business decisions Describe the impact of the tragedies of September 11 on corporate finance Explain the 10 principles that form the foundations of financial management Explain what has led to the era of the multinational corporation

The Goal of the Firm The Goal of the firm is maximization of shareholder wealth or Maximization of the price of the existing common stock

Benefits of Maximizing Shareholder Wealth Direct benefit to shareholders Societal benefits as businesses compete to create wealth Includes effects of all financial decisions

Profit Maximization Stresses the efficient use of capital resources Not specific to time frame for profits to be measured Goals are not precise, allow for misinterpretation Ignores uncertainty and timing

Legal Forms of Business Organization Sole Proprietorship Partnership Corporation

Sole Proprietorship Owned by an individual Owner holds title to assets Unlimited liability Termination occurs on owner’s death or by owner’s choice

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

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

How The Finance Area Fits Into a Corporation

Objectives of Income Taxation Raise revenues for government expenditures Achieve socially desirable goals Achieve economic stabilization

Types of Taxpayers Individuals—employees, self-employed persons, members of partnerships Report income on personal tax return Corporations—separate legal entity Report income on corporate tax return Distributed dividends taxed to shareholders Fiduciaries—estates and trusts Pay taxes on undistributed income

Taxable Income Taxable Income—Gross income less tax deductible expenses, plus Interest income and dividend income Gross Income—Dollar sales from a product or service less cost of production or acquisition Tax Deductible Expenses—Operating expenses (marketing, depreciation, administrative expenses) and interest expense Dividends paid are not deductible

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

Corporate Tax Rates Income Rate $ 0 - $50,000 15% $ 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

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

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 life Capital Gains and Losses—Capital Gains taxed as ordinary income. Capital losses cannot be deducted from ordinary income.

Ten Principles That Form The Foundations of Financial Management

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.

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.

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.

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

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

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.

Principle 7: The Agency Problem Managers won’t 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

Principle 8: Taxes Bias Business Decisions When a new project is evaluated, the after-tax incremental cash flows are considered

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

Principle 10: Ethical Behavior Is Doing The Right Thing, and Ethical Dilemmas Are Everywhere In Finance Each person has his or her own set of values, which forms the basis for personal judgments about what is the right thing

Finance And The Multinational Firm U.S. corporations are looking to international expansion Collapse of communism Free market system developing in the third world Freer access to international markets