1. Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr.
Chapter 1
An Introduction to the Foundations of Financial Management – The Ties that Bind

2. Foundations of Finance
Chapter Objectives
Identify the goal of the firm.
Compare the various legal forms of business organization and explain why the corporate form of business is the most logical choice for a firm that is large or growing.
Describe the corporate tax features that affect business decisions.
Describe the corporate tax features that affect decisions.
Explain the 10 principles that form the foundations of financial management.
Explain what has led to the era of the multinational corporation.
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3. Foundations of Finance
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
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4. Foundations of Finance
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
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5. Benefits of Maximizing Shareholder Wealth
Good decisions are those that create wealth for the shareholder
Societal benefits as businesses compete to create wealth
Includes effects of all financial decisions
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6. Legal Forms of Business Organization
Sole Proprietorship
Partnership
Corporation
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7. Foundations of Finance
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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8. Foundations of Finance
Partnerships
Two or more owners
General Partnership
Each partner is fully responsible for liabilities
Limited Partnerships
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9. Foundations of Finance
Partnerships
Limited Partnership and Limited Liability Company
Allows one or more partners limited liability based on amount of capital invested
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.
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10. Foundations of Finance
Corporation
Legally functions separate and apart from its owners
Can sue, be sued, purchase, sell, and own property
Owners who dictate direction and policies
Elect a board of directors
Investors liability is restricted to amount of investment in company
Life continues with transfer of ownership
Taxed separately
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11. Comparison of Organizational Forms
Large growing firms choose the corporate form
Ease in raising capital
Limited liability
Transfer of ownership is simple
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12. Comparison of Organizational Forms
Sole Proprietorship and General Partnership
Unlimited liabilities
Not as easy to raise capital
Limited Partnership
Limited liability for partners
Practical number of partners restricted
Restricted marketability of interest in partnership
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13. Organizational Form and Taxes
Corporation
Double taxation of dividends
Tax act of 2003 limited tax rate on dividends to stimulate the economy
Ends in 2008 unless Congress takes action
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14. Organizational Form and Taxes
S-Type Corporations
Benefits
Limited liability
Taxed as partnership
Limitations
Owners must be people
Can’t be used for joint ventures between two corporations
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15. Organizational Form and Taxes
Limited Liability Corporations
Benefits
Limited liability
Taxed like a partnership
Limitations
Qualifications vary from state to state
Can’t appear like corporation otherwise will be taxed like one
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16. The Role of the Financial Manager in a Corporation
HOW THE FINANCE AREA FITS INTO A CORPORATION
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17. Objectives of Income Taxation
Raise revenues for government expenditures
Achieve socially desirable goals
Economic stabilization
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18. Foundations of Finance
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
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19. Computing 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
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20. Computing Taxable Income ($000’s)
Sales $50,000
Cost of Goods Sold ,000
Gross Profit $27,000
Operating Expenses
Administrative Expenses $4,000
Depreciation Expense ,500
Marketing Expenses 4,500
Total Operating Expenses $10,000
Operating Income $17,000
Other Income
Interest Expense ,000
Taxable Income $16,000
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21. Foundations of Finance
Corporate Tax Rates
Income Rate
$ 0 - $50, %
$50,001 - $75, %
$75,001 - $10,000, %
Over $10,000, %
Additional surtax:
5% on income between
$100,000 and $335,000
3% on income between
$15,000,000 and $18,333,333
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22. Foundations of Finance
Marginal Tax Rates
Rates applicable to next dollar of income
Used in financial decision-making
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23. 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.
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24. Ten Principles That Form The Foundations of Financial Management
“…although 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.”

25. 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 its expected return will be.
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26. 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.
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27. Principle 3: Cash—Not Profits—Is King
Cash Flow, not accounting profit, is used as our measurement tool.
Cash flows, not profits, are actually received by the firm and can be reinvested.
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28. 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 selected, versus what they will be, if the project is not selected.
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29. Principle 5: The Curse of Competitive Markets
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.
Product Differentiation, Service and Quality can insulate products from competition
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30. 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.
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31. 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.
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32. Principle 8: Taxes Bias Business Decisions
The cash flows we consider are the after-tax incremental cash flows to the firm as a whole.
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33. Principle 9: All Risk is Not Equal
Some risk can be diversified away, and some cannot
The process of diversification can reduce risk, and as a result, measuring a project’s or an asset’s risk is very difficult.
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34. Foundations of Finance
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
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35. Finance and the Multinational Firm
U.S. corporations are looking to international expansion
Collapse of communism
Acceptance of free market system developing in the Third World countries
PC’s and the internet
Freer access to international markets
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