An Introduction to the Foundations of Financial Management The Ties that Bind

Chapter 1

Learning Objectives
1. 2.

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. Explain the 10 principles that form the foundations of financial management.

3.

4.

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Slide Contents
1. 2. 3.

4.

5.

The Goal of the Firm Ten Principles of Finance Legal Forms of Business Organization Role of Financial Manager in a Corporation Income Taxation

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1. The Goal of the Firm

The Goal of the Firm

The goal of the firm is to maximize shareholder wealth. Shareholder wealth is measured by share prices. Thus shareholder wealth maximization would imply maximizing the price of common stock.

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Part of Coca-Colas Vision

Maximizing return to shareowners while being mindful of our overall responsibilities.

http://www.thecoca-colacompany.com/ourcompany/mission_vision_values.html (retrieved March 13, 2007)

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Benefits of Maximizing Shareholder Wealth

Good corporate decisions are those that create wealth for the shareholder. Society benefits as scarce resources are directed to the most profitable use by businesses competing to create wealth.

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Share Price Changes (during last two years as of June 29, 2007)

Google: Share price increased by nearly $200 or around 67% (from around $300 to $500) wealth created.

Yahoo: Share price decreased by nearly $8 or around 23% (from around $35 to $27) wealth destroyed.

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Why is Profit Maximization not the appropriate goal?

Profit maximization goal is unclear about the time frame over which profits are to be measured. It is easy to manipulate the profits through various accounting policies. Profit maximization goal ignores risk and timing of cash flows.
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 Ten Principles: 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.

Principle 1: The Risk-Return Trade-off

Would you invest your savings in the stock market if it offered the same expected return as your bank? We wont take on additional risk unless we expect to be compensated with additional return.

Higher the risk of an investment, higher will be its expected return.

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The Risk-Return Trade-off

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Principle 2: The Time Value of Money

A dollar received today is worth more than a dollar to be 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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Principle 3: CashNot ProfitsIs King

In measuring wealth or value, we use cash Flow, not accounting profit, as our measurement tool.

Cash flows are actually received by the firm and can be reinvested. On the other hand, profits are recorded when they are earned rather than when money is actually received.
It is possible for a firm to show profits on the books but have no cash!
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Principle 4: Incremental Cash Flows

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.

This difference reflects the true impact of a decision.

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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 (through Service, Quality) and cost advantages (through economies of Scale) can insulate products from competition.
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Principle 6: Efficient Capital Markets

The values of securities at any instant in time fully reflect all publicly available information.
Prices reflect value and are right. Price changes reflect changes in expected cash flows (and not cosmetic changes such as accounting policy changes). Good decisions drive up the stock prices and vice versa.
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Principle 7: The Agency Problem

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. Agency conflict reduced through monitoring (ex. Annual reports), compensation schemes (ex. stock options), and market mechanisms (ex. Takeovers).
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Principle 8: Taxes Bias Business Decisions

The cash flows we consider for decision making are the after-tax incremental cash flows to the firm as a whole.

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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 projects or an assets risk is very difficult. A projects risk changes depending on whether you measure it standing alone or together with other projects the company may take on.

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All Risk is Not Equal

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Principle 10:

Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are Everywhere in Finance

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. Ethics are relevant in business and unethical decisions can destroy shareholder wealth (ex. Enron Scandal).

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 Legal Forms of Business Organization

 Legal Forms of Business Organization

Sole Proprietorship Partnership (General & Limited) Corporation Hybrid (S-Type & LLC)

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Sole Proprietorship

Business owned by an individual

Owner maintains title to assets and profits

Unlimited liability
Termination occurs on owners death or by owners choice

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Partnerships

Partnership: Two or more persons come together as co-owners. Two types of partnership: General or Limited

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Partnership - General

All partners are fully responsible for liabilities incurred by the partnership.

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Partnerships - Limited

One or more partners can have limited liability 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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Comparison of Organizational Forms

Sole Proprietorship and General Partnership

Unlimited liabilities Not as easy to raise capital Limited liability for partners

Limited Partnership

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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. Shareholders liability is restricted to the amount of investment in company. Life of corporation does not depend on the status of its owners. Ownership can be easily transferred.
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The Trade-offs: Corporate Form

Benefits:

Limited liability Easy to transfer ownership 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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Double Taxation example

Income Federal Tax @25% After tax Income

= $1,000 = $250 = $750

What will be the total tax if the company chooses to distribute the after-tax profits to shareholders as dividends?
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Double taxation

If corporation distributes the profits as dividends to shareholders, shareholders will have to pay taxes on dividends.

Assume shareholders are taxed @20% on dividend income or 20% of $750 = $150 Total tax = 250 + 150 = $400 or 40%
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Hybrid (S-Type Corporations)

S-Type Corporations

Benefits

Limited liability Taxed as partnership Owners must be people Cant be used for joint ventures between two corporations
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Limitations

Hybrid (Limited Liability Corporations - LLC)

Limited Liability Corporations (LLC)

Benefits

Limited liability Taxed like a partnership Qualifications vary from state to state

Limitations

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. Role of Financial Manager in a Corporation

The Role of the Financial Manager in a Corporation (figure 1.1)

HOW THE FINANCE AREA FITS INTO A CORPORATION

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The Role of the Financial Manager in a Corporation (figure 1.1)

We focus on the duties generally associated with the treasurer and how investment decisions are made.

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Role of finance in Business

Where to invest (capital budgeting decision) How to raise money (Capital structure decision) How to manage cash flows from daily operations (Working Capital decision)

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. Income Taxation

Income Taxation

Objectives:

Raise revenues for government expenditures

Achieve socially desirable goals

Economic stabilization

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Types of Taxpayers

Individual

Corporation

Includes employees, self-employed persons, members of partnerships Reports income on personal tax return Reports its income and pays tax on profits Distributed dividends taxed to shareholders

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Computing Taxable Income for Corporation

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

Operating expenses (marketing, depreciation, administrative expenses) and interest expense Dividends paid are not deductible

Tax Deductible Expenses

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Computing Taxable Income ($000s)

Sales Cost of Goods Sold Gross Profit Operating Expenses Administrative Expenses Depreciation Expense Marketing Expenses Total Operating Expenses Operating Income Other Income Interest Expense Taxable Income $50,000 23,000 $27,000

$4,000 1,500 4,500

$10,000 $17,000 0 1,000 $16,000
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Corporate Tax Rates

Income $ 0 - $50,000 $50,001 - $75,000 $75,001 - $10,000,000 Over $10,000,000 Rate 15% 25% 34% 35%

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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Example: Computing taxes on taxable income of $16m

$50,000 $25,000 $9,925,000 $6,000,000 Surtax * * * * .15 .25 .34 .35 = = = = 7,500 6,250 3,374,500 2,100,000
= 11,750 = 30,000

.05*($335K-$100K) .03*($16m - $15m)

Total Tax

= $5,530,000
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Marginal Tax Rates

Refers to the tax rate applicable to next dollar of income.

In the previous example, the marginal tax rate is 38% since $16m falls into the 35% tax bracket with a 3% surtax.

In financial decision-making, marginal tax rate is more relevant than average tax rate.

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 Finance and Multinational Firm

Why do companies go abroad?

To increase revenues To obtain cheaper resources (land, labor, capital, raw material)

To reduce the burden of government regulation (ex. Environmental laws, taxes, labor laws) To increase global exposure
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Risks/challenges

Country risk (changes in government regulations, unstable government, economic changes)

Currency risk (fluctuations in exchange rates)

Cultural risk (differences in language, traditions, ethical standards etc.)
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Finance and the Multinational Firm

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. the domination of the auto industry by Honda, Toyota, and Nissan) International movement has been spurred by:

Collapse of communism Acceptance of free market system developing in Third World countries Technology and communication (PCs and the internet) Improved transportation
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