1. Chapter 1 Getting Started— Principles of Finance

2. Slide Contents Learning Objectives Introduction Key Terms
Finance: An Overview
Three Types of Business Organizations
The Goal of the Financial Manager
The Five Basic Principles of Finance
Key Terms

3. Learning Objectives
Understand the importance of finance in your personal and professional lives and identify the three primary business decisions that financial managers make.
Identify the key differences between the three major legal forms of business.

4. Learning Objectives (cont.)
Understand the role of the financial manager within the firm and the goal for making financial choices.
Explain the five principles of finance that form the basis of financial management for both businesses and individuals.

5. 1.1 FINANCE: AN OVERVIEW

6. What is Finance?
Finance is the study of how people and businesses evaluate investments and raise capital to fund them.

7. Three Basic Questions Addressed by the Study of Finance:
What long-term investments should the firm undertake?
How should the firm raise money to fund these investments?
How can the firm best manage its cash flows as they arise in its day-to-day operations?

8. Why Study Finance?
Knowledge of financial tools is critical to making good decisions in both corporate world and personal lives.
How will GM’s strategic decision to invest $740 million to produce the Chevy Volt require the expertise of different disciplines within the business school?

9. 1.2 THREE TYPES OF BUSINESS ORGANIZATIONS

10. Business Organizational Forms
Business Forms
Proprietorships
Sole
Partnerships
Corporations

11. Sole Proprietorship
It is 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.
The sole proprietors typically raise money by investing their own funds and by borrowing from a bank.

12. 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
The business ceases on the death of the proprietor
Harder to raise money

13. Partnership
A general partnership is an association of two or more persons who come together as co-owners for the purpose of operating a business for profit.

14. Partnership (cont.) Advantages: Disadvantages:
Relatively easy to start
Taxed at the personal tax rate
Access to funds from multiple sources or partners
Disadvantages:
Partners jointly share unlimited liability
It is not always easy to transfer ownership

15. Partnership (cont.)
In limited partnerships, there are two classes of partners: general and limited.
The general partner runs the business and faces unlimited liability for the firm’s debts, whereas the limited partner is only liable up to the amount the limited partner invested.

16. Corporation
If very large sums of money are needed to build a business, then the typical organizational form chosen is the corporation. The corporation is legally owned by its current set of stockholders, or owners.

17. Corporation (cont.)
Corporation legally functions separately and apart from its owners (the shareholders). Corporation can individually sue and be sued.
The Board of directors are elected by the shareholder, and the board appoints the senior management of the firm.

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

19. Limited Liability Company (LLC)
Limited liability company (LLC) combines the tax benefits of a partnership (no double taxation of earnings) with the limited liability benefit of corporation (the owner’s liability is limited to what they invest).

20. Figure 1.1 Characteristics of Different Forms of Business

21. Figure 1.2 How the Finance Area Fits into a Corporation

22. 1.3 THE GOAL OF THE FINANCIAL MANAGER

23. The Goal of the Financial Manager
The goal of the financial manager must be consistent with the mission of the corporation, which is to maximize shareholder’s wealth.

24. Coca-Cola’s Vision Statement
To achieve sustainable growth, we have established a vision with clear goals for:
Profit
People
Portfolio
Partners
Planet

25. Corporate Mission
While managers have to cater to all the stakeholders (such as consumers, employees, suppliers etc.), they need to pay particular attention to the shareholders.
If managers fail to pursue shareholder wealth maximization, they will lose the support of investors and lenders. The business may cease to exist and ultimately, the managers will lose their jobs!

26. Ethics in Finance What do we mean by Ethics?
Give examples of recent financial scandals and discuss what went wrong from an ethical perspective.

27. Sarbanes-Oxley Act (SOX)
SOX Act was passed in 2002 “to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes”.
SOX Act mandates senior executives to take responsibility for the accuracy and completeness of financial reports.

28. 1.4 THE FIVE BASIC PRINCIPLES OF FINANCE

29. PRINCIPLE 1:Money Has a Time Value
A dollar received today is worth more 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.

30. PRINCIPLE 2: There is a Risk-Return Trade-off
We won’t take on additional risk unless we expect to be compensated with additional return.
Higher the risk, higher will be the expected return. Note expected return may not be equal to the realized rate of return.

31. Figure 1.3 There Is a Risk-Return Tradeoff

32. PRINCIPLE 3: Cash Flows Are the Source of Value
Profit is an accounting concept and measures a business’s performance. Cash flow is the amount of cash that can actually be taken out of the business.
It is possible for a firm to report profits but have no cash.

33. Incremental Cash Flow
Financial decisions in a firm should consider “incremental cash flow” i.e. the difference between the cash flows the company will produce with the potential new investment and what it would make without the investment.

34. PRINCIPLE 4: Market Prices Reflect Information
Investors react quickly to news/information and decisions made by managers.
Good News ==> Higher stock prices
Bad News ==> Lower stock price.

35. PRINCIPLE 5: Individuals Respond to Incentives
Managers (as agents) respond to incentives they are given in the workplace. If their incentives are not properly aligned with those of the firm’s stockholders (the principal) they may not make decisions that are consistent with increasing shareholder value leading to agency costs.

36. PRINCIPLE 5: Individuals Respond to Incentives (cont.)
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 (such as auditors, bankers, security analysts, credit agencies)
The underperforming firms seeing their stock prices fall and face threat of being taken over and have their management teams replaced.

37. Key Terms Agency problem Capital budgeting Capital structure
Corporation
Debt
Dividends
Equity

38. Key Terms (cont.) Financial markets General partner
General partnership
Limited liability company (LLC)
Limited partner
Limited partnership
Opportunity cost

39. Key Terms (cont.) Partnership Shareholders Shares Sole proprietorship
Stockholders
Working capital management