2. 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.
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3. 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
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4. What is Finance? Finance applies specific value to things owned
services used
decisions made
Financial management
organization’s approach to valuation
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5. 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.
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6. 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
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7. 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.”
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8. 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.
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9. 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.
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10. 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)
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11. Figure 1-1
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12. 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.
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13. 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)
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14. 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)
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15. 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)
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16. 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.
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17. The Role of a Financial Manager in a Firm
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18. 4. The Legal Forms of Business Organization
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19. 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
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20. 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.
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21. 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
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22. 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.
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23. Double Taxation example
Assume earnings before tax = $1,000
Federal = $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.
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24. Double Taxation example
If corporation distributes all the profits as dividends to shareholders ==> Shareholders will be taxed again.
Assume dividends are
= 15% of $750 = $112.50
==>Total tax = = $362.5 or 36.25%
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25. 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
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26. 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
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27. 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
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28. 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
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29. 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.)
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30. Review: Key Terms Agency problem Corporation Efficient market
General partnership
Incremental cash flow
LLC
Limited Partnership
Partnership
Sole proprietorship
S-type corporation
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